theTypology of Financial Scandals ( Mutual Funds )..Tulipmania this is thename coined for thefirst pyramid investment scheme in history.In 1634tulip bulbs were traded in a special exchange in Amsterdam. People used these bulbs as means of exchange and value store. They traded them and speculated in them. therare black tulip bulbs were as valuable as a big mansion house. thecraze lasted four years and it seemed that it would last forever. But this was not to be.thebubble burst in 1637. In a matter of a few daystheprice of tulip bulbs was slashed by 96%!This specific pyramid investment scheme was somewhat different from theones which were to follow it in human financial history elsewhere in theworld. It had no organizing committeeno identifiable group of movers and shakerswhich controlled and directed it. Alsono explicit promises were ever made concerning theprofits which theinvestors could expect from participating in thescheme or even that profits were forthcoming to them.Since thenpyramid schemes have evolved into intricate psychological ploys.Modern ones have a few characteristics in common:Firstthey involve ever growing numbers of people. They mushroom exponentially into proportions that usually threaten thenational economy and thevery fabric of society. All of them have grave political and social implications.Hundreds of thousands of investors (in a population of less than 3.5 million souls) were deeply enmeshed in the1983 banking crisis in Israel.This was a classic pyramid scheme: thebanks offered their own shares for salepromising investors that theprice of theshares will only go up (sometimes by 2% daily). thebanks used depositors moneytheir capitaltheir profits and money that they borrowed abroad to keep this impossible and unhealthy promise. Everyone knew what was going on and everyone was involved.theMinisters of FinancetheGovernors of theCentral Bank assisted thebanks in these criminal pursuits. This specific pyramid scheme arguablythelongest in history lasted 7 years.On one day in October 1983ALL thebanks in Israel collapsed. thegovernment faced such civil unrest that it was forced to compensate shareholders through an elaborate share buyback plan which lasted 9 years. thetotal indirect damage is hard to evaluatebut thedirect damage amounted to 6 billion USD.This specific incident highlights another important attribute of pyramid schemes: investors are promised impossibly high yieldseither by way of profits or by way of interest paid. Such yields cannot be derived from theproper investment of thefunds sotheorganizers resort to dirty tricks.They use new moneyinvested by new investors to pay off theold investors.thereligion of Islam forbids lenders to charge interest on thecredits that they provide. This prohibition is problematic in modern day life and could bring modern finance to a complete halt.It was against this backdropthat a few entrepreneurs and religious figures in Egypt and in Pakistan established what they called: Islamic banks. These banks refrained from either paying interest to depositors or from charging their clients interest on theloans that they doled out. Insteadthey have made their depositors partners in fictitious profits and have charged their clients for fictitious losses. All would have been well had theIslamic banks stuck to healthier business practices.But they offer impossibly high profits and ended theway every pyramid ends: they collapsed and dragged economies and political establishments with them.thelatest example of theprice paid by whole nations due to failed pyramid schemes isof courseAlbania 1997. One third of thepopulation was heavily involved in a series of heavily leveraged investment plans which collapsed almost simultaneously. Inept political and financial crisis management led Albania to theverge of disintegration into civil war.But why must pyramid schemes fail? Why cant they continue foreverriding on theback of new money and keeping every investor happynew and old?thereason is that thenumber of new investors andthereforetheamount of new money available to thepyramids organizers is limited. There are just so many risk takers. theday of judgement is heralded by an ominous mismatch between overblown obligations and thetrickling down of new money. When there is no more money available to pay off theold investorspanic ensues. Everyone wants to draw money at thesame time. Thisevidentlyis never possible some of themoney is usually invested in real estate or was provided as a loan. Even themost stable and healthiest financial institutions never put aside more than 10% of themoney deposited with them.Thuspyramids are doomed to collapse.Butthenmost of theinvestors in pyramids know that pyramids are scamsnot schemes. They stand warned by thecollapse of other pyramid schemessometimes in thesame place and at thesame time. Stillthey are attracted again and again as butterflies are to thefire and with thesame results.thereason is as old as human psychology: greedavarice. theorganizers promise theinvestors two things:That they could draw their money anytime that they want toand That in themeantimethey will be able to continue to receive high returns on their money. People know that this is highly improbable and that thelikelihood that they will lose all or part of their money grows with time. But they convince themselves that thehigh profits or interest payments that they will be able to collect before thepyramid collapses will more than amply compensate them for theloss of their money. Some of themhope to succeed in drawing themoney before theimminent collapsebased on warning signs. In other wordstheinvestors believe that they can outwit theorganizers of thepyramid. theinvestors collaborate with theorganizers on thepsychological level: cheated and deceiver engage in a delicate ballet leading to their mutual downfall.This is undeniably themost dangerous of all types of financial scandals. It insidiously pervades thevery fabric of human interactions. It distorts economic decisions and it ends in misery on a national scale. It is thescourge of societies in transition.thesecond type of financial scandals is normally connected to thelaundering of capital generated in theblack economynamely: theincome not reported to thetax authorities. Such money passes through banking channelschanges ownership a few timesso that its track is covered and theidentities of theowners of themoney are concealed. Money generated by drug dealingsillicit arm trade and theless exotic form of tax evasion is thus laundered.thefinancial institutions which participate in laundering operationsmaintain double accounting books. One book is for thepurposes of theofficial authorities. Those agencies and authorities that deal with taxationbank supervisiondeposit insurance and financial liquidity are given access to this set of engineered books. thetrue record is kept hidden in another set of books. These accounts reflect thereal situation of thefinancial institution: who deposited how muchwhen and under which conditions and who borrowed whatwhen and under which conditions.This double standard blurs thetrue situation of theinstitution to thepoint of no return. Even theowners of theinstitution begin to lose track of its activities and misapprehend its real standing.Is it stable? Is it liquid? Is theasset portfolio diversified enough? No one knows. thefog enshrouds even those who created it in thefirst place. No proper financial control and audit is possible under such circumstances.Less scrupulous members of themanagement and thestaff of such financial bodies usually take advantage of thesituation. Embezzlements are very widespreadabuse of authoritymisuse or misplacement of funds. Where no light shinesa lot of creepy creatures tend to develop.themost famous and biggest financial scandal of this type in human history was thecollapse of theBank for Credit and Commerce International LTD. (BCCI) in London in 1991. For almost a decadethemanagement and employees of this shady bank engaged in stealing and misappropriating 10 billion (!!!) USD. thesupervision department of theBank of Englandunder whose scrutinizing eyes this bank was supposed to have been was proven to be impotent and incompetent. theowners of thebank some Arab Sheikhs had to invest billions of dollars in compensating its depositors.thecombination of black moneyshoddy financial controlsshady bank accounts and shredded documents proves to be quite elusive. It is impossible to evaluate thetotal damage in such cases.thethird type is themost elusivethehardest to discover. It is very common and scandal may erupt or never occurdepending on chancecash flows and theintellects of those involved.Financial institutions are subject to political pressuresforcing them to give credits to theunworthy or to forgo diversification (to give too much credit to a single borrower). Only lately in South Koreasuch politically motivated loans were discovered to have been given to thefailing Hanbo conglomerate by virtually every bank in thecountry. thesame may safely be said about banks in Japan and almost everywhere else. Very few banks would dare to refuse theFinance Ministers croniesfor instance.Some banks would subject thereview of credit applications to social considerations. They would lend to certain sectors of theeconomyregardless of their financial viability. They would lend to theneedyto theaffluentto urban renewal programsto small businesses and all in thename of social causes whichhowever justified cannot justify giving loans.This is a private case in a more widespread phenomenon: theassets (=loan portfolios) of many a financial institution are not diversified enough. Their loans are concentrated in a single sector of theeconomy (agricultureindustryconstruction)in a given countryor geographical region. Such exposure is detrimental to thefinancial health of thelending institution. Economic trends tend to develop in unison in thesame sectorcountryor region. When real estate in theWest Coast of theUSA plummets it does so indiscriminately. A bank whose total portfolio is composed of mortgages to West Coast Realtorswould be demolished.In 1982Mexico defaulted on theinterest payments of its international debts. Its arrears grew enormously and threatened thestability of theentire Western financial system. USA banks which were themost exposed to theLatin American debt crisis had to foot thebulk of thebill which amounted to tens of billions of USD. They had almost all their capital tied up in loans to Latin American countries. Financial institutions bow to fads and fashions. They are amenable to lending trends and display a herdlike mentality. They tend to concentrate their assets where they believe that they could get thehighest yields in theshortest possible periods of time. In this sensethey are not very different from investors in pyramid investment schemes.Financial mismanagement can also be theresult of lax or flawed financial controls. theinternal audit department in every financing institution and theexternal audit exercised by theappropriate supervision authorities are responsible to counter thenatural human propensity for gambling. themust help thefinancial organization reorient itself in accordance with objective and objectively analysed data. If they fail to do this thefinancial institution would tend to behave like a ship without navigation tools. Financial audit regulations (themost famous of which are theAmerican FASBs) trail way behind thedevelopment of themodern financial marketplace. Stilltheir judicious and careful implementation could be of invaluable assistance in steering away from financial scandals.Taking human psychology into account coupled with thecomplexity of themodern world of finances it is nothing less than a miracle that financial scandals are as few and far between as they are.


ABOUT theAUTHOR

Sam Vaknin is theauthor of Malignant Self Love Narcissism Revisited and After theRain How theWest Lost theEast. He is a columnist for Central Europe ReviewUnited Press International (UPI) and eBookWeb and theeditor of mental health and Central East Europe categories in theOpen Directory and Suite101.Web site:...samvak.tripod.com/ ...samvak.tripod.com/



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