Last one in pays for the party

The term used by English speakers is "gullibility". It has come to refer to the tendency to believe in something without asking too many questions, and therefore open to trickery. In Spanish, the nearest equivalents would be simpleza (simpleness) or credulidad (credulity). But they are not exactly the same. Credulity characterized the behavior of those who thought, contrary to the lessons of history, that their homes were endowed with some magical property that distinguished them from the other objects in the universe and would continue to increase in value for ever. They not only ignored history, but common sense.

Or those who were prepared to pay 35 euros for the holographic bracelets that were all the rage in 2009, and had been invented in California in 2007. According to their inventors, the bracelets contained "holograms set to frequencies that react positively to the body's magnetic field. Everything has a frequency, just like cellphones, WiFi, radio waves, and other similar objects, and they all react with each other. There are frequencies that react negatively with the body, and others that do so positively. We have discovered how to insert them into a hologram, which when it comes into contact with the body brings balance, strength, and flexibility."

Don't worry. You haven't failed to understand the above for lack of education or mental agility. The description makes about as much sense as a sermon by Fidel Castro. The head of the company that distributes the bracelets in Spain told EL PAÍS, without blinking, that his is a technology company. He was unable to explain his product in technical terms, however. "It's like Coca-Cola, the formula is a secret." Right.

Where are the customers' yachts?

There is a story that an out-of-towner arrived in New York sometime around the beginning of the last century wanted to visit the financial district. When the visitor was taken to The Battery, the guide then proudly showed him some of the huge yachts moored there. The guide then proceeded to list the millionaires who owned them. The somewhat naïve visitor eventually asked: "That's all well and good, but where are the yachts belonging to the customers of these men?" Exactly. The story gave rise to a book of the same name. The thinking behind it is that the financial services industries do not exist to make their customers rich, but to relieve them of their burdensome money. Brokers and other related species are able to buy yachts not because they are financial geniuses, but because they have the commercial talent to know how to extract commissions from their placid customers. The moral of this story is that if the customers want to buy a yacht, they need to ask the right questions and take the right decisions... Euros are not usually sold at fifty cents a pop.

The punters who were taken in by the Fórum Filatélico and Afinsa scams would have done well to bear this in mind. Both companies were shut down in May 2006, accused among other things of fraud. They invested their customers' money in postage stamps, and promised high levels of fixed returns independent of the ups and downs of the financial markets. These three promises should have been sufficient to send most investors running. But they failed to see that there had to be a catch.

The simple truth of the operation was that investors' money came in through one door, and went straight out of the other to provide the promised "return" to the initial investors. A classic pyramid scheme. These kind of pyramid schemes typically offer a fixed rate of return of between six percent and 10 percent. They work by rewarding investors with their own money, and that of new investors, rather than with any profits generated by investment. And needless to say, they keep a proportion of investors' money to pay for a lifestyle characterized by private jets and affairs with Russian dancers. The scam works for as long as new investors can be brought in. But eventually, things go wrong. The Spanish authorities estimated that Fórum Filatélico and Afinsa owed about 5 billion euros.

The organizers of the scam spent much time and money on establishing their reputation. This then allowed them to generate the confidence and trust required for more than 300,000 people to believe that they were investing in a decent company run by honest people. They could not imagine for a moment that they were dealing with crooks. Both companies were awarded numerous prizes, and given positive media coverage. In 2005, the then minister of justice awarded the president of Fórum Filatélico the Gold Medal for Higher Management. Two years earlier, a radio station gave the company an award for the best investment product. Just like that. And then in 2005, a well-known consulting company named the firm its Best of European Business. To a large degree, part of the responsibility for the disaster was down to the air of credibility that the company was able to generate, and which in turn convinced the general public that Fórum Filatélico and Afinsa were reasonable investment alternatives.

Eventually in such scams, somebody sets off the alarm. But nobody takes any notice. As long as the revelry is underway, party poopers are ostracized. This is what happened with Fórum Filatelico and Afinsa. Both the consumer watchdog and Barron's financial magazine warned of the scam in 2004 and 2005. But nobody was listening. There wasn't much else to be done. Then a journalist at Barron's took two sets of postage stamps to an interview with a senior member of the board of Afinsa. He wanted to know at how much the company estimated the value of the stamps. One set had been issued in Bulgaria in 1980, and another in Finland in 1920. The journalist asked the Afinsa director the stamps' worth. He in turn replied that they were too new to be worth investing in. He wouldn't buy them. He told the reporter that there was no shortage of unscrupulous people in the stamp market prepared to take advantage of unsuspecting investors with little knowledge of philately, and that he should be very careful. The director then asked the journalist where he had acquired the stamps. "I bought them from Afinsa," he replied, adding that each set had cost him 600 euros. Silence. Once the director had recovered his senses, he came back with: "Right. I am going to find out how we could possibly have been tricked into valuing those stamps at that rate." Not bad. Not bad might also describe the stamp supplier to Afinsa who was found to have 10 million euros in 500euro notes stashed behind a false wall in his newly acquired apartment.

Ponzi, the original

Hyman P. Minski, the respected US economist, defined a pyramid swindle, or Ponzi Scheme, as one that promises extraordinary profits to investors who sign up early, and then repays them with the money of subsequent investors. The high rates of return are attractive, and if the swindler makes a good start, the original investors act as a sales force, and the money supplied by new investors goes to the first in on the scheme. And like epidemics, the number of people infected keeps growing.

Such frauds are known as Ponzi Schemes after Charles Ponzi, who invented the classic pyramid swindle in the years shortly after World War I. He managed to convince around 10,000 people to part with a total of $9.5 million. That would be worth around $150 million today. Nothing compared to what Madoff and Stanford managed. Ponzi promised returns of up to 50 percent in three months. To prove his abilities, he would sometimes pay out in half that time. That is equivalent to around 400 percent growth a year. Hard to resist.

Madoff: the pupil betters the teacher

To date, the Ponzi Scheme concocted by Bernard Madoff is the biggest financial scam in history. Ponzi managed to trick his victims out of $9.5 million, equivalent, as we said, to around $150 million today. Based on differing accounts, Madoff is said to have gotten his hands on around $65 billion. He paid his clients with the money that later arrivals pumped in. He did not invest a single cent of the money he received. We are talking about a stratospheric swindle. He managed to convince the entire planet that he had found an algorithm that allowed him to invest without risk in the stock exchange. As said, he never actually invested any money in the markets. Ponzi would have been proud of him. Bernard Madoff was born in 1938, the same year Time magazine named Adolf Hitler man of the year. He was educated in the dark arts by his parents, who for many years ran a financial kiosk from their own house.

In 1960, Madoff set up Madoff Investment Securities. The company specialized in the sale and purchase of shares in companies too small to figure on the big brokers' radar. These types of stock were known as penny shares, a term that reflected their value.

His first lucky break came at the end of 1960 at the age of 22, when Carl Shapiro, a successful textile baron, walked into his life. Once he realized that Madoff was no dummy, Shapiro gave him $10,000. Madoff now had the taste for bigger investments, but still lacked the cash. He needed more investors. Then he had a great idea. He used his network of feeders to pull in more money. This involved placing commercial agents among privileged groups to draw in more cash. The first in were his father-in-law and two young accountants, Frank Avellino and Michael Bienes, who worked for him. None of them actually had a license to raise funds, so they were already breaking the law by working for Madoff. They promised a return of 18 percent a year, regardless of the whims of the markets. They did not find it hard to pull in clients.

His father-in-law was successful, but Avellino and Bienes really hit the jackpot. Despite the complete impossibility of keeping their promises to investors, nobody seemed too bothered by Madoff's business model. Over time, and with the help of Carl Shapiro, Madoff moved to where the really big money was to be found: Florida and the wealthy residents of the Palm Beach Country Club, in those days home to more millionaires per square inch than anywhere on the planet, where membership cost around $300,000 a year, and members had to prove that their donations to Jewish charity groups were above the $1-million-dollar mark. When Madoff turned up there in the early 1980s, he was already a well-respected figure on Wall Street, and would soon be named president of the NASDAQ. In Florida he became a cult figure.

When out dining in restaurants, he would frequently be approached by strangers asking him to look after their money. Madoff refused to talk about money in public, he never boasted of his achievements, and he never spoke on the phone in front of other people. This strategy served to boost his image further. And so the business continued to grow. In 1992, Avellino and Bienes alone had managed to pull in more than half a billion dollars on behalf of Madoff. The sales strategy remained the same: 20 percent, regardless of the ups and downs of the market. That same year, one suspicious investor contacted the Securities and Exchange Commission (SEC), which brought charges against Avellino and Bienes. The authorities suspected a Ponzi Scheme. But to their surprise, in the following days, the pair returned $440 million to their clients. The SEC didn't ask how they were able to do this, when all their cash should have been invested in the markets. Neither did it occur to the organization to look into Madoff's affairs. When all was said and done, this was one of the most respected figures on Wall Street. But proof of the fraud was now widely available to anybody prepared to look.

In the aftermath, The Wall Street Journal contacted Madoff to check out his rates of return. He was delighted to talk to them. He claimed to have discovered a magic formula that would allow him to generate money even when the markets were on the down. He told the WSJ's journalist of his strategy, based on a secret algorithm that he used to buy stocks and shares. He also said that he was unaware that Avellino and Bienes were not licensed brokers. The Wall Street Journal swallowed the story hook, line, and sinker. After he returned his clients' money, the SEC's investigation pretty much ground to a halt. It closed down Bienes and Avellino's operations, but Madoff was allowed to continue his meteoric rise.

But without his two main feeders, Madoff now desperately needed new sales agents. He turned to Robert Jaffe, Carl Shapiro's son-in-law. Jaffe went to work finding new investors at the Palm Beach Country Club. Madoff was no longer promising 20-percent returns, having lowered his sights to between 10 percent and 15 percent a year. Club members trusted Madoff. They believed that they were investing in reputable companies, and believed his story about the algorithm. The profits were too good to be true, but they believed him. Madoff's network had by now come to include members of European royalty. This had been achieved largely due to a French aristocrat, René Thierry Magon de la Villehuchet, whom he had met in the mid-1980s. But Villehuchet's trust in Madoff cost him his life. When Madoff was arrested, the Frenchman committed suicide. He had invested almost all his money in Madoff's scheme, along with that of his family and friends.

The unavoidable question prompted by the whole Madoff affair is just how it was possible that nobody realized what was going on. The investors had no idea, neither did the regulators, and neither did Madoff's auditor. The answer would seem to have something to do with those auditors, Friehling and Horowitz. Madoff Investment Securities was valued in the billions of dollars. Among its investors were some of the biggest banks in the world, along with aristocrats, Arab Sheikhs, and Hollywood stars. The reality behind it all was a back office and one employee, David Friehling, who worked from home, and didn't even have a secretary.