On Wall Street: the persistence of ‘the bezzle’

Published: January 9 2009 20:52 Last updated: January 9 2009 20:52 There’s a joke about a man unable to get to sleep while staying at a hotel in Las Vegas. He goes down to the roulette table, puts $5 on black and wins. He keeps betting and rides an amazing streak, finally holding well over $1m in chips. Deciding to trust Lady Luck one last time, he loses everything. Returning to his wife in the hotel room, she asks how he did. “Not too bad. I lost five bucks.” Like the gambler, many of Bernie Madoff’s long-time investors had amassed wealth on paper, but their loss was only their initial “investment”. The rest was an accounting fiction. They thought they had it, though, and that gave them satisfaction. In this sense, the money’s power was magnified – it was simultaneously theirs and Madoff’s. In his work on the 1929 crash and its aftermath, John Kenneth Galbraith described this phantom sum as “the bezzle”. “There’s a kind of psychic wealth because there are two parties laying claim to the same pot of gold,” says Richard Parker of Harvard University’s Kennedy School of Government, who recently published a biography of the economist. Galbraith wrote that the bezzle was always present but that it swelled during booms and shrank after a crash. “In good times people are relaxed, trusting, and money is plentiful,” Galbraith wrote. “But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed.” The comparison of Madoff’s operation with that of Charles Ponzi, whose name graces the crime, is somewhat misleading. The original Ponzi scheme and other investment pyramids tend to be short-lived, promising outlandish returns to unsophisticated people. Long-running scams that ensnare the wealthy and savvy require a prolonged period of prosperity to thrive. “When are people going to be defrauded? It’s when the opportunities are plausible,” says Frank Partnoy, a University of San Diego law professor who wrote Infectious Greed, an account of chicanery in the 1990s. Falling into a similar category are investments that, though not fictitious, depend on a fragile chain of financial trust to sustain their value. For every Madoff victim, there are dozens of hedge fund investors who were blindsided by sudden reversals of fortune. The exotic, highly rated instruments the funds held shrivelled to pennies on the dollar or sometimes zero once confidence and liquidity disappeared. Parker is certain that there are many more shoes to drop as the bubble deflates, including more outright frauds like Madoff. “When it tips over, everybody starts to look at their monthly statements more closely and draw them down, and this is the crisis that topples the Ponzi scheme,” he says. Enron and Parmalat-style frauds also emerge in busts. This week saw revelations of fraud at Satyam, the Indian software company. If further proof were needed that investors forget and repeat the errors of the past, the memories of Ivar Kreuger, the Madoff of his day, provides it. The “Swedish Match King” was seen as a genius in the 1920s when his securities were the most widely held in the world. After his 1932 suicide and disgrace, it was assumed that the entire exercise was fraudulent. But Partnoy, who is to release a book on Kreuger, says that creditors eventually recovered 50 cents on the dollar. Partnoy thinks Madoff might have begun legitimately and then shifted over the years, either through theft or hidden losses. “With these Ponzi schemes, in the end there’s financial wealth, but in the beginning there’s (often) real wealth,” he says. As details of his scheme emerge, the Madoff saga will tighten scrutiny of financiers. The bezzle will keep shrinking for a while, but it will grow again and look similar. “The man who is admired for the ingenuity of his larceny is almost always rediscovering some earlier form of fraud,” Galbraith wrote. “The basic forms are all known, have all been practised. The manners of capitalism improve. The morals may not.”