Structure and Operation of a Ponzi Scheme - Assignment Example

TOPIC: Financial Markets (NAME) (COURSE NAME) (INSTITUTION NAME) 19TH MAY, 2009 Question 1. Describe the structure and operation of a Ponzi scheme. In your answer provide a description of the schemes perpetrated by Charles Ponzi and more recently Bernie Madoff. Explain why such schemes are often discovered post a financial crisis. Ponzi scheme operates by giving the investors return for their investment from the money that they pay to the scheme or paying the investors their return using the money paid by other investors. Therefore such scheme doses not pay return from the profits earned through investment as should be the case. So as to attract potential investors Ponzi scheme in their operation offer more appearing returns when compared to other investment scheme like abnormally high return or short-term returns. Ponzi scheme is structured in such a way that it requires investors to constantly bring in money so that the scheme continues running. However such a scheme normally collapses within a short period of time because they are unable to maintain their operations where payments made as return are more than earnings. But in some cases such schemes are discovered by legal authorities and their operations interrupted before they collapse. This is because with increasing number of investors being involved, the chances of the scheme being discovered by legal authorities are high (Utpal, 2003). Ponzi scheme derives its name from Charles Ponzi who was well known for using it in 1920 and he become a millionaire in just six months. The scheme started as a way of earning profits through reply coupons that were traded for postage stamps. But Poizi soon started using his investors’ money to pay the first investors and diverted the other investment money toward his own personal wealth. A profit was supposed to be got by redeeming reply coupon with stamps at a higher cost (Utpal, 2003). The First World War resulted to inflation in Italy which led to a decrease in the cost of postage stamps when expressed in U.S. dollars. Therefore International reply coupons were bought at a low cost in Italy and exchanged in U.S. for stamps at a higher value hence earning some profit from the exchange and Ponzi argued that the net profit that could be earned through these transactions was about 400%. The whole process involved buying an asset in a market where its price was low and then selling the same asset in a market where the price was high and therefore you make profit and this was in no way illegal (Williams, February 4, 2009). Ponzi drum up support from his close friends and associates to support his scheme, promising a 50% investment return within a short period of 45 days. In order to promote his scheme, Ponzi started a new firm which he called "Securities Exchange Company", where those who invested in the firm were promised 50% investment return within 45 days or "double your money" within 90 days (Utpal, 2003). Ponzi was able to attract around 40,000 investors in his scheme all of them together making a large investment of around $15 million. However contrary to what Ponzi had promised only a third of that investment money was returned to them at the end. Investors would mortgage their homes so as to invest in Ponzi scheme and some other investors would invest their life savings. Many of the investors in Ponzi scheme did not take their investment return but reinvested it in the scheme. Ponzi was therefore bringing in investment money into the scheme at a high rate, but the scheme operations were at the same time running a very big loss. How ever since investment money kept flowing in from new investors and reinvestment, existing investors continued being paid with the inflowing money. Inflowing money was what Ponzi used to pay existing investors, as he was not making any profit from the investment since he was not investing in the reply coupons as he had promised his investors. Ponzi was in his scheme able to accumulate too much wealth and he lived a luxuriously life (Edith and Wilchins, 2008). Bernard Madoff Bernard Madoff is another well known figure in the Ponzi scheme. He came to the lime light on his Ponzi scheme in his firm when at the end of the year 2008 he disclosed it to his sons. After disclosing this he was arrested and faced with eleven charges of securities fraud of about $65 billion dollars belong to his investors. Madoff Ponzi scheme is probably one of the largest Ponzi scheme in the history, and most probably the largest investment fraud involving one person. In fact one of his largest investors, committed suicide upon discovering that he had made a loss of $1.5 billion through the Ponzi scheme (BBC News, 23 December 2008). Madoff's Ponzi scheme was similar to the one made by Ponzi in its structure, the difference was only in its pace and marketing. In his scheme rather than offering abnormally high investment returns to all investors, he gave modest and steady investment returns to an exclusive investor, in both down and up markets. Madoff claimed that his investment would not be understood by an outsider, it involved stock purchases. However few such transactions were ever made in the actual sense. If the transaction would have occurred in the way that was clamed by Madoff the volume of transactions would have been much more than the market's capacity (New York Times, 2008). Madoff based his Ponzi scheme on charitable societies which later turned out to be the side-victims, of his Ponzi scheme. He at first used his own social networks, but with time he was able to enter into new venues where he promoted himself and his company to his investors. He the invested the funds he got from the investors as they wished. Every thing seemed to be going on as planed until in 2008 when his abnormal demands for investment money from his investors overwhelmed the Ponzi scheme (New York Times, 2008). Ponzi schemes such as those perpetrated by Charles Ponzi and more recently Bernie Madoff are often discovered post a financial crisis. The reasons for this is because the scheme offer very attractive returns that normally blind the eyes of the investors. The investors are in a hurry not to miss this golden opportunity that is presented to them and so do not take the much needed time to scrutinize the risks that are hidden in the schemes. Since the Ponzi scheme claim to be doing legitimate business they do not attract the attention of authorities until when a financial crises occur and upon investigation the authorities discover that the scheme was operating an illegal business and the was a Ponzi scheme (Marketing Doctor Blog, December 18, 2008). Question 3. Part (a) Read the articles titled “Rio’s China deal gets ACCC nod” and “Chinalco’s bid for Rio Tinto passes the ACCC”. Explain the roles of the ACCC and FIRB. In your answer provide an explanation of the differences between each of these government bodies. In addition explain whether you believe the Chinalco’s bid for Rio Tinto will be allowed by the FIRB, detailing your reasoning. Australian Competition and Consumer Commission (ACCC) is an authority that was created by the Australia government in 1995 as a competition watchdog but it’s independent from the government in performing its mandated functions unlike its sister body the FIRB. The roles of ACCC include protection of the business rights, consumer rights, and business obligations, price monitoring, industrial regulation and prevention of any illegal anti-competitive conduct (Barry, March 26, 2009). ACCC is mandated by the Australian government with the authority of administering the “Trade Practices Act” which helps it in playing its roles. In playing its role ACCC has the authority to take action in the Australian Federal Court so as to be able to enforce the provisions of the Act such as provisions on wrong use of market power, price fixing cartels, and misleading or dishonest conduct. It is the role of ACCC to review mergers. Under the provisions of the Act, ACCC is mandated with the role of regulating certain industries. ACCC plays this role by provision of access to the infrastructure in the country. It is the role of ACCC to ensure that both consumers and businesses have access to information concerning their responsibilities and rights under the act (Barry, March 26, 2009). ACCC, while executing its roles is not supposed to show favor either to consumers or suppliers, but should be focused on achieving a more competitive market with no artificial restrictions. For example, if a given supplier or producer refuses to supply his/her products or services to a certain potential customer or retailer it is not illegal not unless such an action would result into an anti-competitive effect in the market of such a product as a whole. In playing its roles the ACCC has been very vigorous, it has brought court actions against the firms that have been breaching the act and the firms receive severe penalties for not complying. ACCC with the help of a court order makes the non –compliant companies found breaching the act to implement a compliance program that helps them to ensure that in future they are able to comply with the provisions of the act (Barry, March 26, 2009). Recently the ACCC through its mandate under the act of ensuring fair prices for both the suppliers and the consumers has now disclosed that it is unlikely that China will lower the iron ore prices, reduce the current export earnings in Australia from iron ore which is a key export commodity in the country. Therefore according to ACCC the $US19.5 billion compact between China's state-owned Chinalco and Rio Tinto will in no way result into unhealthy business competition. Following these findings, the ACCC has now waved through the compact between China's state-owned Chinalco and Rio Tinto that is thought by many to be controversial. This compact will result into Chinalco gaining direct stakes in Rio's iron ore, copper mines, and aluminium. The compact will also result in Chinalco doubling its Rio stake hence gaining a control of more than 18 per cent. By saying that the Australian exports will not be reduced the ACCC also seam to have considered the nations interest although safeguarding the national interest is primary the role of FIRB which brings a differences between each of these government bodies. However in saying that the iron ore prices will not be brought down the ACCC is executing its role of price monitoring (Barry, March 26, 2009). ACCC clearance comes at a time when there is speculations originating from London that suggests that both Chinalco and Rio Tinto plan to cut BHP Billiton into the deal. From the London speculations, the two have invited BHP Billiton to make a bid that is realistic for Rio's full 30 % stake in the in Chile Escondida copper mine. In the initial Rio-Chinalco compact that is yet to secure clearance by the government in regard to the national interest Chinalco will gain an acquisition of 14.9 % stake of Rio stake in Escondida for $US3.38 billion. BHP is the operator and a major partner of Escondida and is said to have made a less than full offer to Rio for its stake in Escondida before the deal with Chinalco was announced. But the situation now is that Chinalco would not mind Rio considering a full offer from BHP for its stake. The reason for the current change of mind by Chinalco is that it is interested in Rio's iron ore and aluminium assets and not the Chilean copper. If the speculations turn out to be true the ACCC will not have failed in executing its roles because safeguarding the interest of the nation is not its role but that of FIRB (Freed, February 1, 2008). There are also suggestions that the Rio's Gove and QAL alumina operations with avalue of more than $US5.5 billion on a 100 % basis may be included in a renegotiated Chinalco deal so as to make an offset of the value loss resulting from Escondida's exclusion. The speculation raises questions on the critical approval of the Rio-Chinalco deals and whether the deal needs to proceed. If Gove and QAL are to be included in the reworked deal another application for its review by the ACCC may become necessary. Though a review will have been done by FIRB, there is need for another review by ACCC in addition to the one to be done by the FIRB because FIRB role is to advice the Federal Treasurer. The FIRB is therefore not independent in performing its roles as is answerable to the Federal Treasurer unlike the ACCC which is very independent in performing its roles and this makes the differences between each of these government bodies (Espinoza, April 6, 2009). The FIRB has decided to extend its review of the deal by a further 90 days. The reason for this extension could be because when ACCC gave its clearance, it expressed the concern that it was limited to a review of the deal on competition grounds based on its mandated roles and therefore the review board had to find out whether the deal was going to be contrary to Australia's national interest by any means as but of the role of FIRB. ACCC in its review of the deal may have considered the possibility for a vertical integration that would involve Australian Rio's iron ore operations and steelmakers of China. ACCC made this consideration assuming that the various steelmakers and Chinalco are subsidiaries with the same common commercial interests as they belong to the same parent entity. However ACCC ignored the fact that Chinalco is owned 100 % by the China government and therefore Chinalco’s bid for Rio Tinto may not be allowed by the FIRB as this may not be in the national interest of Australia but China. Chinalco’s bid for Rio Tinto may be on its way to success after gaining approval from ACCC after find that the deal will in no way result into unfair competition in the Australian market but a bigger hurdle is still on the way with the pending review by FIRB that will advice the Federal government Treasurer Wayne Swan's on the deals national interest test. The fate of Chinalco’s bid for Rio Tinto now lies with Mr Swan who will make his ultimate decision based on the advice that will be given to him by the FIRB (Barry, March 26, 2009). Australian foreign Minister Mr. Stephen Smith is touring China, where he will defiantly meet with his Chinese counterpart Mr. Yang Jiechi for a strategic dialogue between China and Australia. But Mr. Stephen Smith has expressed his doubts on Chinalco deal being part of their agenda. This sudden relactancy by the government on the deal may mean that the Chinalco’s bid for Rio Tinto may not be allowed by the FIRB (Barry, March 26, 2009). Mr Smith is spearheading a series of Australian government ministers that are expected to be going to China on official visits. The others that are on the list including Australian Trade Minister Mr. Simon Crean who will be visiting China to discuss trade negotiations between the two countries. Next month Mr. Martin Ferguson who is the Resources Minister is expected to make an official visit to China where he is planning to find out the shared opportunities that exist in the Australia-China relationship. Mr Smith is expected to have discuss with Chinese government on the progress that have so far been made on free trade negotiations between Australia and China though he expressed doubts on whether the discussion will go to specific deals like Chinalco’s bid for Rio Tinto. Mr Smith said that “I don't know if we'll have a conversation about specific individual applications for capital investment into Australia. In fact, I would think that would be unlikely. We will have a conversation about general and strategic issues”. This many visit by government officials to China at this time seam to be sending a message that Australian Federal government is doing every thing possible to strengthen its relationship with China. Chinalco’s bid for Rio Tinto may not become an exception and therefore it is likely that the Chinalco’s bid for Rio Tinto will be allowed by the FIRB. Australian Prime Minister Mr. Kevin Rudd has of late been under great criticism for refusing to disclose the details of his meeting with one of the very senior officials from the Chinese Communist Party's. Mr. Barnaby Joyce who is the Nationals Senate leader and who greatly opposes any move by the Federal government of Australia of selling key assets belong to the government to foreigners, has predicted that the Prime Minister meeting with the senior officials from the Chinese Communist Party's must have discussed Chinalco deal even if other things were discussed. Going by the predictions of Mr. Barnaby Joyce it is likely that the Chinalco’s bid for Rio Tinto will be allowed by the FIRB. However Senator Joyce has started an online petition with the aim of giving a voice to the people of Australia as he claim to have received hundreds of emails that all raises a concern about the move by the Federal government to selling mines in Australia to foreign government-controlled firms. Mr. Barnaby Joyce says that “It is my job to give them the capacity to have their voices heard and to relay this concern to the Foreign Investment Review Board and ultimately the treasurer”. Therefore if the review board will respond to the cry of the people of Australia whom it is supposed to serve Chinalco’s bid for Rio Tinto will not be allowed by the FIRB. However this is very unlikely to happen even though the FIRB has a role to look at the nation’s interest unlike ACCC which safeguards the interests of traders and consumers without any reference to the nation’s interests (Sandra, March 25, 2009). Question 3. Part (b) What is the Four pillars policy? Explain the role of the four pillars policy within the banking sector? Four Pillars policy which was originally a 'Six Pillar' scheme is a policy that was created in 1990 by the government of Australia through the Labor Treasurer Paul Keating to help the government in maintaining a separation of four of the largest banks in the country by preventing them from forming a merger or any acquisition of any of these four banks by any of them. According to the information got from The Age, (May 15, 2008) the policy was created to cover “Commonwealth Bank, Westpac, NAB, ANZ and two insurers, AMP and National Mutual”. The Four Pillars policy formation was triggered by the then need to block a merger between National Mutual and ANZ bank. The policy was made with the aim of ensuring that there is a competitive banking market in the country (The Age, May 15, 2008). In 1997, a recommendation was made by Stan Wallis' on the need to break the pillars and allow the banks to be subjected to a similar merger competition tests as the one other businesses were exposed to. However the government Treasurer Peter Costello's only withdrew the pillar status of the two insurers that were covered by the pillar, which were AMP and National Mutual. But he retained the ban on mergers for the four banks were retained for fear that none of the four banks could be considered immune from a foreign takeover (The Age, May 15, 2008). Four Pillars policy creates competitive space in the banking sector for competitor banks to emerge. But it is limitation is that it is limited to the largest four banks, the policy also does not prevent the four banks from eliminating competition when it arises. For example, in the year 2000, CBA was able to eliminate the Colonial group, which then had come out as one of the major bank-insurance combination. In this case the Four Pillars policy was seen as irrelevant as it could not help. The other instant when the four pillar policy proofed not to be well adequate to address the banking problem was in 1997 2when there was a takeover of Melbourne bank by Westpac's and also its takeover of Challenge Bank in1995. The four banks covered by the policy have been opposing it arguing that it makes them not to be internationally competitive, because their size is artificially limited by the Four Pillars policy (The Age, May 14, 2008). References "Marketing Advisory: Madoff Knew His Target Market" Marketing Doctor Blog. December 18, 2008. "Madoff investor commits suicide". BBC News. 23 December 2008. Barry Fitzgerald. (March 26, 2009). Rio's China deal gets ACCC nod, BusinessDay Retrieved on 19th May, 2009 from http://business.theage.com.au/business/rios-china-deal-gets-accc-nod-20090325-9al9.html Edith Honan and Dan Wilchins (12 December 2008). "Bernard Madoff arrested over alleged $50 billion fraud". Yahoo! News. Retrieved on 19th May, 2009 from http://news.yahoo.com/s/nm/20081212/bs_nm/us_madoff_arrest Espinoza, Javier (April 6, 2009). "Rio Tinto on the Hunt for Cash". Forbes.com. Four pillars back on agenda, The Age, May 14, 2008 Freed, Jamie (February 1, 2008). "Chinese raid on Rio Tinto could thwart BHP". Sydney Morning Herald. Sandra O'Malley (March 25, 2009) Chinalco's bid for Rio Tinto passes ACCC, News. Com. Au. Retrieved on 19th May, 2009 from http://www.news.com.au/business/story/0,27753,25241059-31037,00.html The End of the Financial World as We Know It New York Times, 2008. Utpal Bhattacharya (2003). "The optimal design of Ponzi schemes in finite economies". Journal of Financial Intermediation 12: 2–24. Westpac-St George merger won't topple four-pillars, The Age, May 15, 2008 Williams, Walter (February 4, 2009), "The National Ponzi Scheme", Capitalism Magazine, Retrieved on 19th May, 2009 from http://www.capmag.com/article.asp?ID=5409 Read More