Do not be conned, part 1

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Recently, we have discussed Mark to Model schemes. Many people consider these to be a new concept but they have been around for ages. Whilst it must be said that many are above board and do exactly what they say, there are more than a few that are less than honest with their clients. The most famous of these was created by Charles Ponzi who was an Italian immigrant to the US. Ponzi achieved notoriety there after World War I for spectacularly defrauding thousands of investors, using a scheme similar to the one Bernie Madoff got caught out using some 90 years later.

As most people will be aware, both Ponzi and Madoff attracted new investors by promising higher-than-market rate returns, and then paying existing investors these rates with the money entrusted to them by new investors, rather than from any genuine business profits as, in both cases, any real growth was insufficient to cover the promised returns.

Few investment professionals today would admit they could be taken in by a modern-day Ponzi scheme, even though, as the Madoff case showed, a great many people – including some of the supposedly brightest minds in the world of financial services – were fooled as recently as five years ago.

This is why such professionals and the rest of the public ought to be wary. The fact is that vigilance is absolutely necessary today – as much as it was when Madoff was still spinning his story to potential new investors from his offices on Third Avenue – if similarly toxic schemes are to be avoided.

That is because the DNA from “Pops Ponzi” is still out there, potentially lurking in the models of some investment strategies currently being marketed, if some troubling news stories in recent weeks are to be believed.

It seems that certain characteristics of Ponzi’s approach to investment have a way of appearing in investment structures that many experts fail to examine as closely as they perhaps ought to.

Often, as with the Ponzi and Madoff schemes, it is not entirely clear whether some of the latest crop of troubled schemes are the result of deliberate malfeasance, carelessness, or simple ignorance. In the end, of course, it does not matter, as the damage caused to investors, in the form of lost money, is the same.

Many of the schemes that we believe should be looked at with extra attention, when they come striding down a runway towards would-be investors and their advisers, are those based on “mark-to-model” (M2M) formulas. These include some property investment schemes, which derive valuations purely by reference to an assumed multiple of rental values, rather than by any reference to the open market value that the property reasonably could be sold for.

M2M structures have even been known to be used in connection with investment products based on off-plan properties that have not even been completed yet.

Although we hope we are wrong, it could be that in the same way “CDO cubeds” – a super-leveraged variation of Collateralised Debt Obligations – became symbolic of the folly behind the sub-prime bubble in 2008, hypothetical investment models built on top of poorly designed mark-to-model assumptions will come to be seen as a symbol of the 2013 – 2014 period that future investment experts will shake their heads in disbelief over.

Readers of financial publications will have seen references to a number of cases recently which have involved resort properties in popular vacation and retirement hotspots. The reason they are in the news is because investors have suffered when construction failed to take place within a projected time frame, and/or the resale value of comparable properties in the local market plummeted, causing the investment vehicle’s actual pricing to fall short of the developers’ – and investors’ – expectations, based on the models.

Interestingly, Ponzi’s gimmick did not involve property at all, but what was known, at the time, as “international reply postal coupons”.

Ponzi promised to give investors a 50% return on their investment every 45 days, purportedly by buying these coupons at a discounted rate in countries where they were sold cheaply – such as his native Italy – and redeeming them from the US Post Office for a significantly higher face value. Ponzi claimed such transactions yielded returns in excess of 400%.

The main thing to note at this point, though, is this: artificial pricing schemes work because, like Charles Ponzi’s original scheme, they sound entirely plausible. The stories ring true, the assets are real and recognisable, and very often, the people selling them believe they are real and a genuine good deal for investors – and thus come across as trustworthy.

To sniff out the problem, an investor has to pick apart the valuation models being used to explain current and future profits, and bear in mind the old adage that if something seems too good to be true, it almost certainly is.

Unfortunately, this is, too frequently, easier said than done.

To be continued…

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]