The Big Lie Exposed: Wall Street as Institutionalized Fraud

Jeff Schweitzer
Posted December 30, 2008 05:40 PM (EST)

The Big Lie Exposed: Wall Street as Institutionalized Fraud

While investors express dismay and shock about Bernard Madoff's $50 billion Ponzi scheme, nothing about the affair is even slightly surprising. The scandal is perfectly understandable in light of a fundamental truth that nobody wants to accept: Wall Street itself is nothing but a grand Ponzi scam. Wall Street is institutionalized fraud sanctioned by government and blindly accepted by society.

As with religion and faith, people want to believe, and will therefore ignore obvious facts that contradict hopeful thinking about investment returns. The structural flaws of Wall Street are readily apparent to anybody who wishes to see the truth, but few do. Since the early 1930s, voices of reason have been sounding the alarm but investors gorging on hope refuse to listen, and the scam self-perpetuates. Over several postings I intend to convince you beyond any doubt that Wall Street is an elaborate scam, never intended to work for individual investors.

Wall Street is ostensibly in the staid business of analysis, strategy and money management. But we encounter a problem immediately. Brokers, through whom all trades must be completed, make money with every trade, whether that trade is profitable to the investor or not. A more balanced system that would discourage fraud would pay brokers a fee tied to portfolio performance. It can be done. In the current system, any advice offered by anybody on Wall Street will consistently drive toward strategies and trades that make money - not for investors, but for the entrusted adviser. That brokers are not disinterested is only one of many problems. The system is weighted against individuals in favor of the powers on the Street. Make no mistake: you are a target. I will explain why.

The Game is Rigged and Inherently Corrupt

The focus of this first blog about Wall Street is to expose to bright light the false idea that Wall Street is a "free market." In fact, the market is highly manipulated, opaque, inherently corrupt, and rigged against individuals. Wall Street is everything that Adam Smith feared. Smith, the father of modern economics, said that the invisible hand only works in a society adhering to moral norms that prohibit theft and misrepresentation. Yet theft and misrepresentation are the twin gods of Wall Street.

Don't believe me? Well, let us take a trip down memory lane. I would bet that many readers have already forgotten about Drexel Lambert. That is too, bad, because the story of that company presaged the collapse of the Lehman Brothers. We could have learned our lesson then, but did not. During the 1980s, Drexel was the fifth-largest investment bank in the United States. That is until Dennis Levine was charged with insider trading. He pleaded guilty, and implicated Ivan Boesky, who led to Michael Milken.

By 1990 the company was bankrupt. There are deep parallels between the junk bonds (low-rated debt securities) that brought down Drexel and the sub-prime lending and credit default swaps that caused the implosion in 2008. The three are radically different financial instruments, but all share the corrupt idea the something can be created from nothing, that there really is a free lunch. We had plenty of warning; the bright red lights were flashing before us for 30 years. We turned a blind eye. Instead of shoring up the foundation of our financial system, Republicans threw fuel into the fire by legislating even more deregulation, and then more still. The result was absolutely predictable, and inevitable.
The Drexel bankruptcy should have been a wake-up call. Instead, we learned nothing.

Remember Kenneth Lay, Andrew Fastow, and Jeffrey Skilling of Enron, who before Madoff were the preeminent poster boys for corporate greed? They are by no means alone even if the most memorable. In the back alley game of "Fleece the Shareholder," skilled competitors are abundant. Dennis Kozlowski, Tyco's ex-chairman and chief executive, showed some real creativity. Morgan Stanley, always promoting an image of steady, conservative, trustworthy values, agreed to pay $50 million to settle federal charges that investors were never informed about compensation the company received for selling certain mutual funds.

Disinterested brokers? Hardly. Before that the SEC settled with Putnam Investments, the fifth largest mutual fund company, which allegedly had allowed a select group of portfolio managers and clients to flip mutual fund shares to profit from prices gone flat. Dick Strong of the Strong Funds admitted to skimming his investors to benefit himself. Sound like Madoff? What was Strong's punishment? Strong was allowed to sell his fund business for hundreds of millions of dollars.

Think you are safe with mutual funds? The headline in the USA Today on Friday, September 3, 2004, read "Fund scandal investigation is nowhere near an end." Christine Dugas writes: "Nearly two dozen [mutual] fund firms have been implicated in the scandal, and several executives have resigned or been forced out." Mutual fund firms agreed to fines totaling more than $2.6 billion in more than 100 settlements. But don't get your hopes up. Little of the $2.6 billion was ever returned to shareholders.

No, indeed, you are only treated well if you are one of the wealthy clients. Some mutual funds allowed those favored few to buy and sell shares in rapid-fire fashion. Oddly, this practice is actually legal, but harmful to innocent shareholders not lucky enough to be included in the inside game. That would be you. The game, while profitable to those who are allowed to play, costs long-term shareholders, like you, millions of dollars a year. Why? Because mutual funds are forced to keep more assets in cash to accommodate these excess trades, and along with that comes an increase in trading costs, which funny enough are passed on to all shareholders. That would be you.

The corruption does not stop there of course. We also have the issue of late trading. Fund shares, unlike stocks, are priced only once daily at their 4 p.m. closing price. That is true for you, but not for favored clients. Some funds allowed a few big clients to lock in the closing price after 4 p.m., letting them profit from late-breaking news. That is the ultimate insider trading.

Even corporations have the presumption of innocence until proven guilty, but the list of firms tied to the mutual fund scandal investigation is impressive, and includes Janus, Strong, Bank of America's Nations Funds, Bank One's One Group funds, Alliance Capital, Prudential Securities, Fred Alger Management, Merrill Lynch, and Wilshire Associates. And you were surprised that Wall Street melted down in 2008?

Perhaps most annoying, the practice that led to the mutual fund scandal in the first place was never addressed by regulators, even as the foundation was collapsing underneath them. Well-connected investors still had the chance to trade after the market has closed long after the scandal broke. Any effort to increase shareholder power was and is vigorously fought. A proposal that would force the SEC to give shareholders a greater voice in selecting board members was defeated in October 2004. Commissioner Harvey J. Goldschmid, an advocate of the proposal, said "The commission's inaction at this point has made it a safer world for a small minority of lazy, inefficient, grossly overpaid and wrongheaded CEOs." And we were unprepared for the collapse this year?

The ugly truth does not end here by any means. Long before sub-prime lending started a chain reaction that brought our economy to its knees, the once-venerable Fannie Mae was accused of fleecing investors. The Wall Street Journal reported that the Justice Department opened a formal investigation in October 2004, following reports that the mortgage company may have manipulated its books to meet earnings targets. This is after Fannie tried to hinder an official investigation by refusing to provide relevant information. Oddly, the Enron scandal ultimately revealed Fannie's alleged deception, when the energy company's collapse forced Fannie Mae to replace Arthur Anderson with a new auditor. Nobody can say with a straight face that we did not have sufficient warning that the house of cards was on wobbly ground. The corruption at Fannie Mae was blatantly obvious, yet nothing was done. And we're not done.

WorldCom has the fine distinction of perpetrating accounting fraud that led to one of the largest bankruptcies in history prior to Lehman Brothers. The public first learned of this crime in June 2002. WorldCom filed for bankruptcy in July 2002. At issue was the discovery of improper bookkeeping concerning billions of dollars. But here is where you, the small individual investor, should focus your attention. Evidence shows that the accounting fraud was discovered as early as June 2001, when several former employees gave statements alleging instances of hiding bad debt, understating costs, and backdating contracts. However, WorldCom's board of directors did not investigate these claims. In June 2001, a shareholder lawsuit was filed against WorldCom, but it was thrown out of court due to lack of evidence. Yet one year later the hard reality of that fraud was brought to light, but to no benefit to small-time investors.

Rite Aid executives were accused of securities and accounting fraud that forced the drugstore chain to restate more than $1 billion in earnings. Executives at the company were been charged with colluding in overstating Rite Aid's income in every quarter from May 1997 to May 1999, forcing the company to restate results by $1.6 billion, the largest restatement ever recorded, according to the SEC, at that time.

And who can forget the Adelphia Communications scandal? In that sordid case, the company inflated earnings to meet Wall Street's expectations, falsified operations statistics, and concealed blatant self-dealing by the founding family, the Rigas, who collected $3.1 billion in off-balance-sheet loans backed by Adelphia.

But wait, there's more! Call now and we'll double the offer. Wall Street's dark secrets get even worse. The September 6, 2004, issue of Newsweek pointed out that when investors lose money, they can go to arbitration, but that the option is more illusion than reality. Critics complain that the system is "stacked against the little guy" because the arbitrators are closely aligned with the brokerage firms, with industry ties that any objective observer would call a blatant conflict of interest.

Well, OK, if arbitration is stacked against individual investors, at least we have recourse through the courts, right? Wrong. In March 2006, the U.S. Supreme Court issued a ruling making it harder for investors to join forces to fight fraud lawsuits against Wall Street companies. The 8-0 decision blocks state class-action lawsuits by stockholders who contend they were tricked into holding onto declining shares. The Court wanted to prevent "wasteful, duplicative litigation."

This ruling is seen as a major victory for Merrill Lynch, which faced numerous lawsuits stemming from Eliot Spitzer's 2002 investigation into that firm's shady practices. This was before Eliot was caught with his pants down. In that investigation, if you recall, Spitzer brought to light records revealing that Merrill Lynch analysts recommended that investors buy stocks described in internal memos as "dogs" or "disasters." Disinterested brokers? Right. And we are simply shocked that Wall Street collapsed in 2008.

Do you get the clear sense that something is rotten in Denmark? Do you begin to understand that Wall Street is not there to protect your interests? This small sampling of corruption is not an exception that proves the rule; corruption is the rule. The patients are running the asylum. Small investors do not stand a chance. Criminality is so pervasive, so deeply structural, so inherent to the system that brief moments of honest transaction are simply incidental. Madoff is inevitable; he is Wall Street.

Wall Street is the product of a long trail of greed, crime and corruption. The market looks nothing like that envisioned by Adam Smith. In stark contrast to Smith's theories, the Street's history is nothing but one of fraud for the simple reason that the entire enterprise is built on a deeply fraudulent idea: that the future can be predicted. That is the next myth I will debunk in the blog to follow.