Black Hole

Two years ago I was on a plane with a senior partner at a large investment bank, and he was filling me in on the latest gossip from the city.  Christmas time is bonus time in the city, and 2006 was a good year.  He’d heard that there were going to be around 10,000 people in the city receiving bonuses north of £1 million.  In the hedge fund world the top six individual bonuses worldwide would be north of $1 billion, with the largest at around $3 billion.

I don’t know if the figures were true – in the banking world it seems to be customary to talk up your numbers – but there would have been some substance to them.  I don’t know if I was supposed to be impressed with the figures, but I wasn’t – I was absolutely horrified.  For years the financial world had been conjuring money up from nowhere in all manner of ways – in some instances this would be genuine value creation, but increasingly had been looking more like black magic.  I simply didn’t understand where this money was coming from and how the rest of us could afford to be giving away such vast amounts to our bankers and financial managers.  It makes a lot more sense now.

This is the year when it finally all came tumbling down.  The latest incident in what has been a great year of shame for the financial community emerged last week when Bernard Madoff, a major figure on Wall Street for fifty years, fessed up to a massive fraud.  Madoff ran a network of funds that had been returning unfeasibly high and consistent returns for many years.  It turned out that his whole operation was a great big “Ponzi” or pyramid scheme – he invented his profits each year and paid them out of the new funds that were flooding in to his apparently successful operation.  This year, with the markets collapsing and a lot of his customers asking for their money out, his house of cards came down leaving a $50 billion black hole.  It’s a colossal amount of money – it only took $1.46 billion to bankrupt Barings – and much of it has been lost by charitable foundations.  Most of the losers in this affair have yet to be disclosed – there are going to be some nasty surprises to come.

The Madoff money is all gone, but his funds ran fraudulently for twenty years and there were many winners along the way.  Many of the early investors would have taken the dividends year on year and many got their money out before the collapse – with a pyramid scheme, those who get in early and cut and run make big money whilst those still in at the end are left holding the baby.  The administrators of the fund took huge amounts out each year for their services.

Madoff is, in some ways, a microcosm of the whole financial system.  Year in year out the institutions have made unfeasibly high returns.  To keep the wheels rolling they’ve become fashion boutiques, forever marketing the latest financial trends – typically new ways to sell the family silver without it feeling that way.  Risk generally equates to higher return, and they’ve found ways to take more risk than ever before.  As with the pyramid scheme they’ve taken vast amounts out, paid out in bonuses, and they’re leaving the rest of us to pick up the pieces.  The massive bail out of the banks will be paid for by every man woman and child in the country as we try to plug the vast black hole left by years and years of rampant financial excess.

Today is a historic day – this evening the Fed cut its interest rate target in the US potentially to 0% (it is set in a range of 0%-0.25%).  It’s never been below 1% before.  The markets seem to like this news, but there’s a scary angle to it.  Outside of interest rate control there isn’t a massive amount the Fed can do to moderate the economy, and negative interest rates don’t make sense (although they can happen).  It feels like the last throw of the dice.  I think there will be negative sentiment – the US markets may turn down tomorrow.