It’s not just gullible investors who’ve fallen in this trap — the best and the brightest have also succumbed.
Whatever religions might say, the lure of easy money, of making money from money, remains an integral part of human character. And this phenomenon gets manifested repeatedly, both in developing countries like India, and in the so-called “mature” markets in the west. In India, for example, stories of people offering to double the money in three months, or offering say guaranteed returns of 4 per cent per month, keep getting reported with reasonable regularity. The promised returns are given for a few months, before the “entrepreneur” vanishes.
Quite apart from gullible individuals, even bankers and corporate finance managers are not immune to the temptation. In the securities scam of 1992, one foreign bank had allowed a broker free run of its treasury as he promised “higher than market” returns on the bonds! The spate of cases involving large losses on currency derivatives in India, which have come out over the last 15 months, evidence the gullibility of too many corporate executives and managements. Having been involved in an advisory capacity in a large number of such cases, one was repeatedly amazed how otherwise sensible people signed the contracts, too often without understanding the implications; the skewed risk-reward relationships. Bagehot, the famous 19th century editor of The Economist, had argued that “all people are most credulous when happy”. However, most of the adventurous currency derivative contracts in India, seem to have been signed by exporters in exactly opposite circumstances: After the sharp, and unexpected, appreciation of the rupee against the dollar in the first quarter of 2007-08.
In his famous book on the stock market crash of 1929, Galbraith commented that the Securities and Exchange Commission was created as a response to the malpractices in the stock market; while it prescribed elaborate prospectus requirements, no way was found to persuade the investor to actually read the prospectus before investing. There is little evidence of any change in investor psychology since, as the Bernard Madoff Ponzi scheme evidences! Reports indicate that at least one set of material put out by an investment manager, explicitly warned the prospective investor that the broker “could abscond with those assets” but he still managed to collect $2.75 billion! Some of the professionally-managed fund-of-funds had also incorporated explicit warnings into their marketing material, but the brave investors were not deterred. Not only the fund-of-funds, but even supposedly conservative banks, charging fees for their services, like Spain’s Santander, put large amounts of their clients’ moneys with Madoff, and are being sued for negligence by investors in Europe, the US and Latin America. At least some banks seem to be accepting their liability and compensating the investor. Let alone clients’ money, one Austrian bank had put so much of its own money with Madoff that it has had to be rescued by the Austrian government. (Austrian banks appear more prone to adventurous investment strategies, as also witnessed in the case of Refco, a bankrupt broker, World Money, November 7, 2005).
Many other banks have lost huge amount money by investing in AAA rated credit derivatives, yielding more than plain vanilla AAAs. Clearly, the lure of making an extra buck is irresistible. As J P Morgan Chief Executive Jamie Dimon said in Davos, “some really stupid things were done by American banks and American investment banks. To policymakers, I say: Where were they?” A nice way of passing the buck! The fact is that in too many cases, there has been gross negligence in performing “due diligence” by the bankers.
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Karl Marx had warned a century and half ago that crisis of capitalist credit markets occur “where the ever-lengthening chain of payments, and an artificial system of setting them, has been fully-developed”. Interestingly, John Kay in his new book The Long and Short of it argues that the more the number of fee-earning intermediaries between the investor and the final investment, the lesser the gains for the former. He calculates that, if, Warren Buffet had used a fund-of-funds (charges 1.5 per cent plus 10 per cent of profits) to invest money in hedge funds (2 and 20), and if the actual returns were identical to Buffet’s superlative performance, out of his personal wealth of $62 billion, $57 billion would have gone to the middlemen, leaving him with just $5 billion! There were even longer chains of middlemen with their cuts at each stage, from the time a sub-prime loan originated to the time it finally became a CDO — no wonder the losses are so huge!
Tailpiece: In his essay “Economic possibilities for our grandchildren”, Keynes wrote that, in a hundred years, people would realise that “avarice is a vice, that the exaction of usury is a misdemeanor, and the love of money is detestable … We shall honour those who can teach us to pluck the hour and the day virtuously and well, the delightful people who are capable of taking direct enjoyment in things,…”. Obviously, he was too optimistic.