Elliott Epstein

Rearview Mirror

Deluded by fantasy known as a ‘sure thing’

He was considered a financial wizard, a man who built a business empire using new methods of selling securities and leveraging money. It was shocking, therefore, when his empire suddenly collapsed and he was charged with criminal securities fraud.

This isn’t only the story of Bernard Madoff’s precipitous downfall in 2008. It’s also the story of Samuel Insull’s in 1932. But for the three-quarters of a century separating the two, it could be the same story.

Just as Insull’s fall was a symptom of the Great Depression, Madoff’s has become symptomatic of the current economic crisis.

During 2008, $6.9 trillion in stock market wealth was wiped out as the Dow Jones Industrial average slumped by almost 34 percent, the worst record on Wall Street since 1931 when stocks plunged by over 40 percent.

Insull, who came to the U.S. from England at age 21 to work as inventor Thomas Edison’s personal secretary, rose rapidly in Edison’s organization to become president of the newly formed General Electric Company. In 1892, he moved to Chicago and began building his own sprawling enterprise, consisting mainly of electrical utility and transportation corporations, with assets climbing to about $2 billion.

Insull’s business acquisitions in the late 1920s included Central Maine Power Company and Lewiston’s major textile manufacturers, Bates, Hill and Androscoggin.

Insull financed his acquisitions by using cutting edge techniques of selling stock to the general public (instead of just the wealthy) and “leveraging” his cash investment through corporate acquisitions. Holding companies owned by Insull borrowed money to purchase controlling interests in subsidiary companies, offering the subsidiaries’ assets as collateral for new loans or getting “upstream” loans directly from the subsidiaries. .

When the Great Depression struck, Insull’s business, unable to meet its loan payments or obtain more credit, folded, wiping out 600,000 shareholders. He was later tried and acquitted on securities fraud charges and died in 1938.

Fortunately for Lewiston and for Maine, CMP and the textile mills managed to continue operating on their own.

Madoff, a former president of the Nasdaq stock exchange and an enormously successful Wall Street trader for over 48 years, was regarded as a pioneer in the use of computer technology to disseminate stock quotes and execute trades, creating efficiencies that helped pave the way for an explosion of trading volume in the 1990s.

Madoff’s troubles stemmed from his operation of a hedge fund, whose customers included many prominent investors, universities and major charities.

Arrested and charged with securities fraud on Dec. 11, 2008, he is accused of having run a “Ponzi” scheme, one which generated unusually high returns for existing fund investors (over 10 percent annually for 17 years) by paying them, at least in part, with funds obtained from new investors. Such a system cannot be sustained indefinitely, especially in a down market. When clients sought to withdraw $7 billion from the fund in 2008, the scheme quickly unraveled.

Estimates of the losses to Madoff’s customers run as high as $50 billion, the largest single debacle of its kind. It is unclear how many of these losses will be recovered, as investors scramble to file claims in bankruptcy court and with the underfunded Securities Investor Protection Corporation (SPIC).

Both Insull and Madoff were extremely aggressive financiers who rode a long wave of speculation, deceiving others and probably themselves into believing the wave would never break

At the heart of this deception was the “bull” market, a sustained upswing in securities prices, which starts legitimately with a growing economy but often morphs into risky financial gimmickry and over-optimism bordering on wishful thinking. When a “bull” market turns around and becomes a “bear” market, many are financially ruined.

In the 1920s, the gimmick was buying on “margin.” An investor could plunk down as little as 10 percent of the price of a stock purchase and borrow the rest on a margin (also known as a “call”) loan. If a stock went, say, from $1 to $2, the buyer could leverage a personal investment of $1 into a tidy profit of $10. With the widespread expectation stock prices would keep rising and frenzied speculators driving them up, more and more people bought on margin, among them investors in Insull’s companies.

When prices finally headed down, however, the leveraged investments became de-leveraged. Buyers were forced to come up with money to cover their margin loans or let brokers sell their stock at a loss in order to repay the loans. A spate of margin selling panicked investors and accelerated the market’s decline. Call loans, along with other forms of credit, quickly dried up.

In the post 9/11 period, several gimmicks contributed to an overheated market, the chief ones being securitized mortgages and over-the-top investment strategies of hedge funds like Madoff’s.

Lax lending practices by banks and mortgage companies made home mortgage money easily available, even to borrowers with poor credit or those with insufficient income to repay the loans. The financial institutions that originated these risky loans quickly passed along the risk by selling them on the secondary market, where they were bundled or “securitized” and resold to investors.

Coupled with low interest rates, easy lending led to an orgy of mortgage borrowing, home sales, housing construction and rising house prices, which fueled a speculative bubble in real estate, construction and banking starting in 2003. The bubble began to burst in late 2006 and, by 2008, was sending shock waves into other sectors of the economy and the stock market.

At the same time, hedge funds – managed private investment funds open to a limited range of wealthy, sophisticated investors – became increasingly important players on Wall Street. As a “hedge” against losses, they often relied on short-selling, options and derivatives, practices which resembled wagering more than traditional investing. At their peak in 2008, hedge funds may have had as much as $2.5 trillion under management.

The high-stakes mentality of hedge funds, coupled with the absence of significant government oversight, made them particularly vulnerable to a bear market.

Figures like Bernard Madoff and Samuel Insull are lionized in prosperous times and demonized in bad times.

In the end, however, they are nothing more than a product of our own persistent self-delusion that there’s such a thing as a “sure thing.”

Elliott L. Epstein, a local attorney, is founder and board president of Museum L-A and an adjunct history instructor at Central Maine Community College. He can be reached at [email protected]

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