The market need not be a Ponzi scheme-Roger Lowenstein - Madoff Fraud -Market Impact Commentary

In October, Columbia University’s business school honored its most famous investing guru, Benjamin Graham, with a series of panel discussions loosely connected to the market crash, which was then accelerating. The panelists, of which I was one, had contributed to an updated version of Graham’s 1930s textbook, whose signature themes are caution, avoidance of speculation and — at all costs — the preservation of capital. The day we met, the Dow Jones industrial average fell 350 points en route to one of its worst months ever.

J. Ezra Merkin, a Wall Street sage, noted philanthropist and professional money manager, seemed to embody more than any of the other panelists the fear that was gripping traders. When it was suggested that the government should stop intervening in markets and bailing out banks, Merkin rejoined that the system had cracked and desperately needed help. As the world now knows, Merkin had entrusted close to $2 billion of his investors’ money to someone even less dependable than the Dow — that is, the accused Ponzi artist Bernard Madoff. I have no reason to think that Merkin, at the time, had any knowledge of the fraud that was soon to secure his 15 minutes of fame, but that afternoon at Columbia now seems pregnant with latent connections. Perhaps Madoff’s investors lost a greater percentage of their money, and lost it more suddenly, than the rest of us. But beyond these mere matters of degree, is there really any difference?

At least for investors of attenuated time horizons, there is not. Public-securities markets are a wondrous artifice precisely because they offer permanent capital to industry and short-term liquidity to investors. Think about it: a General Electric or a Google sells stock to the public and then retains the proceeds — the capital — indefinitely. Even if the companies earn a profit, by selling more light bulbs or Internet ads, they are under no obligation to pay out the gains in dividends. How, then, do the shareholders claim their reward? Why, by selling their stock to other investors, of course. This means that, in the short term at least, each investor is dependent on the willingness of other investors to hop on board. If other investors go away, prices (even of solvent companies) plummet, to devastating effect on those who sell.

In a Ponzi scheme, there is no G.E. or Google underneath the pyramid: only air. Outgoing investors are paid from the money put up by new ones. And the game for Madoff ended, as Ponzi schemes always do, when he ran out of suckers.

In theory, stocks and bonds are more valuable than air. But when investors get hooked on trading securities (as distinct from owning them), especially ones that are overvalued, they are courting disaster. In retrospect, this was true of the legions that invested in mortgage-backed securities and in the banks that owned them, not to mention the many other companies affected indirectly. Nobody was thinking about what these companies were worth, only about the next quotation on the screen.

This was doubly true for the banks that held those wearily complex and difficult-to-value mortgage bonds. Look at the post-mortem issued by UBS, one of the world’s largest banks, which has suffered mortgage-related losses of some $50 billion (enough to bail out the auto industry several times over). Discussing one particular write down, the bank admitted, “The super senior notes were always treated as trading book (i.e., the book for assets intended for resale in the short term), notwithstanding the fact that there does not appear to have been a liquid secondary market.” Legally, UBS was a bank; conceptually, it was investing with Bernie Madoff.

There is, of course, an alternative to this madness. Which is to invest for the long term, independent of the market action on any given day or year. This is what most small investors pretended, and maybe believed, they were actually doing.

Robert Barbera, the chief economist at ITG, an investment firm, says there are really three schools of investing. There are people who think they can identify superior stocks and bonds over the long term and selectively invest in those that they deem to be undervalued. Second, there are people who recognize that they don’t have this ability and resolve to salt away a fixed portion of their savings, month after month, in a generic and diversified portfolio. Though the first approach requires considerably more talent and is not recommended for novices, both should work.

What does not work is believing you are following either strategy No. 1 or 2 when you are actually engaging in the third approach — which is, essentially, following the crowd, day by day and hour by hour. At the top of the market, investors told themselves they were disciplined and in for the long haul. Now they are selling or refraining from investing. Some misjudged their liquidity needs and have come under pressure to raise cash; others have simply lost heart. Either way, they are dependent on new money to come in for them to get out.

Benjamin Graham’s premise (which he did not abandon, even in the depths of the Great Depression) was that, sooner or later, markets will reflect underlying corporate values. Thus, he wrote, long-term investors had a “basic advantage” over others, because they could ride out bubbles and crashes rather than be gulled during such highs and lows into, respectively, buying or selling. In other words, for those who invest with prudence and an eye toward long-term values, the market need not be a Ponzi scheme. While stocks periodically go for roller-coaster rides, the earning power of the U.S. economy, albeit with serious fluctuations, endures. The people who chased unrealistic returns at the top, like those who are selling now, have simply cashiered their “advantage” to play a game that more nearly resembles Bernie Madoff’s.

Roger Lowenstein, an outside director of the Sequoia Fund, is a contributing writer for the magazine. His most recent book is “While America Aged.”