I’m sure there are others who have talked about this, but I was struck recently by the different treatment of paper gains (or losses) economically and psychologically versus legally. Specifically, I have been thinking about the “value destruction” that has happened since we entered the recession… what… 1 ½ years ago?
So Stephen Schwarzman of Blackstone (ah… silly BX, the fund you love to hate) was nice enough to apprise us of the fact that between 40 and 45% of the world’s wealth has been destroyed in the past year and a half. Certainly, anyone who owns a house, owns a retirement plan, or owns any equity outside of $FAZ has felt this wealth destruction personally and painfully. And the investors with Madoff, who have not seen their investments merely drop off a precipice but have actually seen it burned to a crisp in front of their eyes, would probably laugh at the optimism of a number that is less than 100.
But when you look a little deeper, past the hysteria that is media, you realize that Madoff did not lose the infamous $50 billion. In fact, his losses are probably going to come out to be between $10-$17 billion. Why the discrepancy? Well, it depends on if you are talking about “real” losses or “paper” losses.
Now, don’t get me wrong. Even at its best estimate, $10 billion lost is an unbelievable, horrific number, and I genuinely don’t understand why we don’t have a strict liability rule imposing life sentences (or capital punishment for those who are into that kind of thing) for intentional fraud over… say… $100 million? However, think of the different implications for the Madoff investor who thinks he lost $500,000 versus $100,000 (I’m using the same 5x magnitude of difference between the reported amount Madoff lost and the best estimate of what he lost): $500,000 being the amount that the investor believed owed to him from Madoff’s fund based on the reports that Madoff apparently single-handedly falsified month after month after month, and $100,000 being the amount that the investor actually put into Madoff’s fund over the investing period.
The problem is, people truly believe in their paper gains, and they make all sorts of decisions based upon these gains. There are people who decide to retire early, rather than continuing to work for an extra (or 5) years. More insidious is the fact that people agree to reward their money managers based upon year to year paper gains. For example, the infamous 2 and 20 of hedge funds, where they collects a yearly 2% fee and 20% of the profits off paper profits made on their investments.
Until recently, the lucky ones were translating these paper profits into real profits. In other words, they were cashing out. If you think of the Madoff example, the investigators believe that Madoff lost all that money in 2 ways: (1) obviously, he was skimming plenty off the top for himself and (2) by paying out real money to redeeming investors (who basically converted fake paper gains into real gains). And since these investors had every right to believe that money was theirs, I believe that the authorities are admitting that they will have an almost nonexistent case for clawing back any of these redeemed amounts.
Similarly, this is why so many pundits and bloggers have been commenting on the fact that outside of Madoff, much of what has pulled us into this recession has been one, giant, global ponzi scheme. The housing bubble was exacerbated by a whole lot of easy credit premised on fake paper gains. Again, back to the way that paper gains affect decision making – it isn’t necessarily illogical to take out a 2nd mortgage or a HELOC if you get a yearly appraisal showing an increase in the value of your house of $10,000 one year, $20,000 the next.
The problem with Stephen Schwarzman’s observation of the destruction of wealth is… can you really have a destruction of wealth when so much of it was illusory to begin with?
Think of the incongruity of the financial system we’ve been living in for the past few decades versus the good old tax code. Under U.S. federal income, an individual does not have to pay taxes on their gains or losses until those gains/losses are realized. So if you have invest $100 in stocks, watch those stocks zoom up to $500 and then collapse to $10, you never have to pay taxes on that $400 gain that you theoretically had while the stocks were on an upward trajectory. The taxman knows not to take from you until you’ve locked in your own gains.
So why do we allow money managers to get away with it?
I know that there are market cheerleaders out there that will argue that simple diversification takes you out of this risk. Although this may be true 90, or even 99% of the time, it’s hard to take this argument seriously when we are in the midst of one of those perception changing black swan events. It’s like the various pooled payment stream securities, the CMBS, ABS, CDO…. Diversification can only work if failure risks are not correlated. What we are discovering is that, given enough leverage, and enough of an asset bubble based upon paper gains, failure risks are shockingly closely correlated.
I think we need a new design for safety. I learned this from my family, who learned it by having to deal with the turmoil that was/has been China for most of the first half of the 20th century. Invest. And when that investment has increased by 50% (and the % can be adjusted), take out 1/3 of the investment (or 50% of the initial investment). Do this until you have recovered 100% of your initial investment. The rest can stay in the investment for growth. In this situation, no matter how bad the situation gets, the principal is safe.
I understand that this is not a recipe for growth… in fact, it may be very much a growth anti-recipe. And let’s not go down the inquiry of where you can put your initial investment safely besides under your mattress (even then, not that safe if there is inflation… or zombies). But it is a strategy for us tin-foil hat folks, who just don’t want to be the suckers in a crooks game anymore.
Update (3/11 @ 10:50AM) According to this @NYT article, apparently, the court appointed trustee handling the Madoff dissolution has to try to recover past withdrawals by investors above and beyond their initial investment.
Update (3/13 8:02PM) NPR's Planet Money did a funny podcast about the very issue of exacly how much money was lost in Madoff's ponzi scheme. My favorite part was Harvey Pitt (former SEC chief) arguing that the amount lost should include the opportunity cost of the money invested with Madoff. Except with the global assets market in such a bust, one has to wonder what exactly was the opportunity cost lost. (And no, I'm not suggesting that people would have lost even more had they invested outside of Madoff, because I'm fairly certain that it would have been hard for the majority of these folks to lose more than 100% of their investment.)