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. Beware, ponzi schemes are everywhere.
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 pyramid 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.
Protect Yourself From Ponzi Schemes
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 from Ponzi schemes?
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.
More Ways To Protect Yourself From Ponzi Schemes
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.
Further Reading
Here are some additional articles to enjoy.
- Does Bernie Madoff Win In The End?
- What Happens When A P2P Borrower Stops Paying?
- What Is A Good Short-Term Investment? A $280,000 Windfall Needs A New Home
- Is Insider Trading Hard To Detect?
For more resources check out my:
- Top financial products page to find the best products for your finances
- Invest in real estate page to invest in my favorite asset class,
- Free wealth management page to manage your money better.
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Hey Sam,
I found it really interesting how you focused on how the psychological reaction to a Ponzi scheme being unravelled would have an effect on the financial markets. Any news on these three potential schemes? I’ve done some Googling but couldn’t find anything newer than February when you posted this.
I hedge my holdings against extreme market movements like this by holding Fairfax Financial Holdings. They are a really interesting company that is similar to a Canadian Berkshire Hathaway – their main business is insurance but they also do restaurants and have tons of international exposure.
Their common stock portfolio is also very hedged and they have a variety of CPI-linked derivatives that are set to payout if major world economies experience any deflation.
Hopefully they can help protect my portfolio against major losses. When Brexit happened, they were my only holding in the green.
Thanks for the great read,
FC
Hey Sam,
This topic hits too close to home. I don’t blog about it (outside of my about me page) but maybe I will in the future. In my past life, 2008, I had money in two Ponzi Schemes that unraveled right around the time Madoff’s fund collapsed and the housing and stock markets tanked. My family lost everything because everything dried up at once; lost houses, cash reserves, stock values, etc.
I hear people say all the time that they wouldn’t fall for a Ponzi. I said that too, until I realized I was in a few. These operators are slick, the create fake trading documents, fake bank statements, fake verification of deposits, and even have fake bankers and traders to talk to. It’s insane how evil Ponzi operators are and how deep the lies go.
Ponzi’s are everywhere. I hope none of your followers never goes through the experiences I went through.
Oh man, that is tough to hear. Was the ponzi scheme an investment fund just like Madoff’s?
I’m wary about any money I invest in a private fund as well from a non-big reputation firm. Who really knows?!
One was just like Madoff’s but on a smaller scale and the other was bridge loans for builders. Both collapsed around the same time due to market dips. When the covers were pulled back by the feds, it turns out the investment fund was totally fake, just taking on new money to pay investors. The real estate Ponzi was a real fund that bridged loans backed by real estate, but they promised to be in 1st position at less than a 60% LTV, turns out they were in 2nd and 3rd position on everything.
Were you able to get some of your money back from the fund at least? Madoff victims have for some.
No monies yet. I’m doubtful I’ll ever see it. The ringleader is still in jail. I lost it all but gained so much. My family is in a much better place now and that’s invaluable. Here’s the scumbags that stole some of my money. –
Im not sure the premise of this article makes sense. By definition a ponzi scheme doesnt invest in anything, it just takes money from new investors to pay old ones. So there wouldnt be any positions to liquidate. Madoff didnt own a single security in his fund.
Sam,
As I was reading this article and thinking about saving more cash, I couldn’t help but wonder exactly where I should be keeping it. With all the talk of negative interest rates these days, I’m hesitant to keep my liquid assets in the banks. Not that I’m advocating for under the mattress saving, but I’m a little confused as to where the “safest” place to save is (if there is such a thing anymore). What are your thoughts on credit unions vs online banks vs traditional banks? Thanks!
Hi Kay,
Have you read this article? https://www.financialsamurai.com/should-i-buy-cds-during-a-stock-market-correction/
A CD ladder is fine. People just have to come to grips that interest rates will be lower for longer. The people taking a 30 year fixed mortgage is today have not come to grips yet.
I just laughed out loud reading the first paragraph–if only I had seen that article before this one. Thanks for the link and for taking the time to answer personally!
Well that’s pleasant… We just bought a farm as an effort towards self-sufficiency. Hopefully, they will lower our operating costs and help wade through another ’08!
The current environment with the market and other external factors appears to be setting up a “perfect storm event.”
Oil, China, Ponzi schemes, inflation of the dollar (2% is ludicrous, much higher), bubbles building again in the housing sector (cheap money low rates), the bubble in the stock market etc.
I think many of these are on the brink of creating a catastrophic event, that could bring to light many of the other stresses in the market. What do you guys think?
) 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.
– If like Madof they don’t own anything there is nothing to sell. No? Or say they turned 100bil into 10bil. – not much left to sell anyway.
– Who says they have to sell? Fiduciary takes over and supervises the assets as the legal process works its way through and the sells the remains over 12 months.
The financial system seems pretty brittle but not sure this particular issue leads anywhere. Vastly smaller then the Saudis liquidating hundreds? of billions just paying bills the last few months.
600+ Ponzi Schemes….unreal. I like the tips you gave about how to protect yourself, especially to not pay down your mortgage. It’s better to have access to cash than to have a smaller mortgage.
There most assuredly are Ponzi schemes out there waiting for a trigger to blow up. They have been there in the past, and will be there in the future. What can you do? Don’t use margin or leverage in your investments. These are ingredients in a recipe for disaster. Live way below your means, (save 50% of your income) and have money in liquid reserves. And for God sakes, ignore the media when they say the world is ending. If the market does go down drastically, you will have the opportunity to build a fortune on what everyone else is giving away.
I am just not a huge fan of market timing and using hedges. I feel fine with having a huge enough cash buffer on the side as a emergency fund. I am 31, still young, so I still have my ability to work and hustle if hard times do present themselves without selling assets if we do see more downside or not. Otherwise it will be a game of going long or going short, going short is not for the faint hearted or for most people out there. All I can do is diversify the hell out of my net worth and stick with a asset allocation that will give me the will to weather good and bad times. The options are build a business that will be cash flow positive through any possible events, invest in rental properties that are cash flow positive and see high occupancy regardless of marketing conditions, and the main one is live below your means, don’t have too many fixed expenses have the ability to scale back easily if you need too during hard times… I think everyone should always align themselves to any possibility at any given time. You see we never know how long good times will roll and we don’t know how long the bad times will last. So we must find a happy balance so we can get through any situation.
I see new Ponzi schemes popping up every day online.
Seems like there’s a market dedicated to it, HYIP.
Doesn’t seem to get too much attention or traffic but they are constantly popping up.
Easy to spot them, I just hope everyone else can.
Sam, I would love your opinion on these financial moves I plan to make in the next few weeks.
I have about 1m in cash, which I intend to use to 1) pay off my grad loans with 8 percent interest; 2) payoff a mtg with a 8.85 interest (refi is not an option. Its a celoc, second position); 3) buy out my partner on a property. These 3 moves will use 800k of my 1m, but will increase my monthly cash flow by 6k.
Is it a bad move to trade liquidity for better cash flow?
I can’t possibly give you good advice w/out knowing the full picture. If you want to discuss in detail, as those are large financial moves with big money at stake, I recommend filling out my personal finance consulting page.
When I saw the headline, I was expecting an article about Social Security haha
LOL
Sam,
What are your thoughts on purchasing an online business as of right now? I’m not sure what experience you have with this but I’m in the market to purchase an online business but I’m not really sure what would happen to multiples during an economic downturn. Seems like businesses are still undervalued and I’m not sure if I should wait or buy now to create another “passive” income stream. I’m afraid if I wait multiple will continue to rise.
Thanks!
P.S.
Thanks for the previous info about KL, Malaysia. I had a great time eating on Jalon Alor and checking out the Petronas Towers!
Good to hear about Malaysia, Kevin! What were you doing there and how long were you there?
Check out: How Income Producing Assets Increase In A Low Interest Rate Environment
I’m a buyer of online income businesses than a seller b/c the multiples are pretty low, but the cash flow is strong.
I was there for a quick 4 day trip to celebrate the New Year. I’m currently teaching english in southern Thailand and had to renew my visa.
Glad to hear you have the same thoughts as me. Just wanted some reassurance to help me avoid any cold feet.
Also, thanks for the article link. I definitely agree with creating digital products to create additional revenue streams. It is one of the reasons I am here teaching in Thailand. Teaching allowed me to feel comfortable quitting my job and moving abroad. It also acted as a hedge while making the transition.
Your ebook also helped me negotiate a $7,500 severance package along with some other benefits. So cheers to that as well!
Wonderful to hear! There’s supposedly a lot of folks building lifestyle businesses in Chiang Mai and Bangkok. Would love to follow your journey once you start a site or buy one. My book also had a partner program if you’re interested in generating additional revenue.
Interesting article. I guess I don’t completely agree that another large ponzi scheme will in and of itself create a huge downturn in the markets / economy. The Madoff ponzi scheme was found out after the market had already crashed due to a ton of other factors (December 2008). That is why the ponzi scheme was discovered; Bernie ran out of money to continue the scheme with the crashing marketplace that was already occurring.
I do hope you are right, and that the confidence of every investor in the world is not shaken. We know what happens when there’s a bank run.
Does anyone think that there should be some regulation on reporters/journalists on publishing information that could be so damaging to our economy? I understand that everyone has a right to know especially people that have invested in a potential Ponzi scheme.
However, if the SEC can do damage control quietly, it seems like that would be better than everyone knowing and creating a ripple affect on other things like jobs, housing, spending, etc.
There will without a doubt be another huge downturn at some point in the future…could it be bigger than 2008? Possibly, but then again if they have already swept 600 of these under the rug quietly why would you think these would not be carefully unwound as well? I would have to imagine the cumulative scale of these 600 would be on par if not way greater than 65B, but I’m not really connected to the industry in anyway. Although the timescales are different, it is similar to saying when the next mega earthquake is going to level the west coast…sadly both will happen, but you can’t plan your life around unforeseen events. Sam is correct though that you on the financial side that you can control, you should not have concentrated assets that would devastate you. Best part is that it is all relative, if the markets and real estate collapse your buying power goes through the roof!
Sam:
I wouldn’t be surprised to see another significant downturn. I track year-over-year employment data (https://wp.me/p6XBS5-5v) and looking back over the past 30 years, we have had three periods where total private employment growth was negative:
12/90 – 3/92 (16 months)
7/01 – 11/03 (29 months)
4/08 – 7/10 (28 months)
The first period marked the Gulf War. The second, the attacks on 9/11. And the third, the great housing recession. Although interestingly, the decline in 2001 actually began before 9/11 and dropped below zero in July prior to the attacks. But I’m sure the attacks pushed the declines into record low territory. In 2009, we had three consecutive months of -5.9% year-over-year declines – by far the worst we have seen.
If you look more recently, since we emerged into positive territory in Aug, 2010, we have been hovering somewhere in the 2% growth range every month. We saw the peak last February and have been trending downward ever since.
Add in a scenario as you describe coupled with instability around the world, including the US elections in the fall, and it’s hard to see much upside for quite a while.
No worries, Yellen will save us.
I don’t wish pain on anyone, but sooner or later, something will have to give to get the global economy back on sound footing. When it does, it will be painful.
Not to go full prepper on you, but should things go seriously sideways, having cash in your bank might be nice, but it may not help you.
Ask the Greeks when they couldn’t get cash from an ATM due to withdrawal limits.
Ask the Cypriots when the government had a bail-in and stole their money from their bank accounts.
Or just ask Jean-Claude “when things are serious you have to lie” Juncker…
Maybe it would be a good time to open a Taxable account and funnel funds into a TSM or SP 500 fund since things are on sale. Thoughts?
By most measures equity markets are still expensive. If you are in your 40s and haven’t started investing yet (God forbid!), waiting 18 months likely does you no harm and may do some good. If instead you are in your 20s or 30s, it’s probably better to establish the habit of monthly investing now rather than worrying about market timing. My personal IPS has me investing in the market each month regardless of which way the market is headed or how many people are tossing themselves out of windows. If we all go to hell, so be it.
I like your proposed investments alot. As a GenXer I was hammered twice (tech and real estate bubbles) before I discovered Boglehead investing and never looked back. As for which index, since both indexes have comparable (and very low) fees, popular wisdom is to invest in the total market rather than just the S&P. Good luck!
I’m only 33 so and have invested fully to 401k for past 8 years and have build out a cash reserve and have a house ibam mortgaging. Just looking for an avanue above tax free accounts to out my money
What would you think about buy real estate in times like now. Were talking about $140-150K condo’s in nice area’s of Houston and renting out. That would take a minimal investment upfront of about 15-20% whereby the Rent would cover the mortgage and then some.
Depends on the Net Operating Income and NOI yield. I think real estate will decline for the next couple years. In Houston, the mass layoffs are coming due to the sustained decrease in oil prices. I’d wait. Things always take a while to correct.
Mass layoffs due to Oil has already happened but Engineering and the economy is still up. There is a big push for rentals in some of the hipper neighborhoods.
For instance, a $140-150K 1 Bedroom upgraded unit (600sq ft) could go for around $1100-1200/mth.
HOA fees about $125-$150/hr
Sounds like your money is burning a hole in your pocket. If you would like to buy now before the pain spreads, that’s fine. Just make sure you’re willing to stay put and hold on for a very long time.
The money is not really burning a whole in my pocket but it seemed like a good opportunity on a property. We already have one rented out in the same area. I will monitor closely and appreciate the input.
Now if only I can stop getting slaughtered in my 401K which is about 85% equities :(
We have a good amount of cash stockpiled (couple 100) and are just looking for ways to use it to generate more streams of income. Having it sit in checking does nothing at this point and 401+ira have been maxed each year.
Any suggestions?
FLyers,
Fellow Houstonian here. Some mass layoffs have already happened, but they’re not over by a long shot. The bankruptcies haven’t even really started yet. Inner-loop Houston real estate is still way overinflated in my view. I expect that in the next couple years we’ll see prices drop by at least 20%, and possibly 40%+ in some neighborhoods. And I’m normally an optimist :)
I’m curious what areas you’re seeing $150k condos in. It seems to me, in the trendy neighborhoods small condos are generally more like $250k+, with townhomes from $500k-1mm. When you say trendy, I assume you mean inner loop, near downtown or the galleria.
Man, $140-150K 1BR upgraded unit (600sq ft), that’s really a bargain considering the prices of RE where I live. I am hoping to invest more in RE as well in the near future, but sounds like maybe I will be better off waiting for a couple more years? What to do with the savings/cash for now, Sam?
Wow. This article sounds like the Faber Report. What do you think the chances if this happening are?. Probably not worth hoarding cash over?
Given your prior work experience and connections to fintech, you seem well connected to those at the heart of the investment banking industry. I am curious if this post reflects the overall sentiment of those in the industry.
As a layperson, I simply see an unprecedented amount of debt both publicly and privately and we just can’t seem to inflate it away. Negative rates in Europe haven’t motivated people to spend. Money velocity is down and people are choosing more stable and nonproductive assets (cash, gold, etc).
Even if they contain these new ponzi schemes and avoid triggering a black swan event, I still see another potential swan. I don’t see any happy ending except to kick the can down the road a couple more years.
I am wondering if those in industry are privately as pessimistic as I am.
Absolutely. Valuations have been CRUSHED in the private market. Lending Club IPOing at $7B market cap and now trading at $2.6B causes massive valuation compression among the private fintech companies. Of course, everybody is still hopeful that things will stabilize. I think the chances of stabilization are around 65%. But that still means that there’s a 35% chance that a ton of well known private companies will go out of business, and very lean times are ahead.
We must control our expenses and find new ways to make money in the meantime. I am hoping my ARM refinance goes through this time around. As an unemployed person who can’t get a worthwhile job, I’ve got to focus on my current income optimization before things get too hairy.
Why do you think the chances of stabilization are at 65% and how long will that stabilization period hold?
Do you think that it is likely we will go the route of Japan?
A single $65B ponzi would be dwarfed by cumulative outstanding energy credit exposure.
CDS pricing and yields currently greater than Lehman era.
This would expose the ponzis.
It’s all about tipping points or one or a set of events that catalyze a collapse. It could be as tiny as a couple horrendous earnings results and forecasts by a couple major companies, or a massive fund blowing up like Long Term Capital.
A $65B+ fund blowing up could very well be that catalyst due to loss of TRUST in the system.
But the energy story is already underway. Wait till credit facilities are redetermined in April. Second liens and secondary offerings are losing steam at this point.
So you think now is the time to buy instead of when things get worse? My experience has always been that things overshoot on the way up and down.
I think you have a four month buying opportunity before there is stability in price. NG weighted producers are very different than oil at this point though. There may be more opportunity in NG.
I would suggest shorting DWTI or DGAZ. If you look back on comments I suggested the Same in August 15 and that would have resulted in a 50% gain. I said “short DWTI. Go to the beach.”
I’m off to the beach in Hawaii for a week next week! Everybody making money during good and bad times right?