Would Bernie Madoff's Fraud Even Be That Bad By Today's Standards?

0:00 All right.

0:00 So, what the[ __] did Bernie Maidoff actually do?

0:04 He is, of course, most famous for running

0:07 the largest Ponzi scheme in financial history,

0:10 swindling investors out of as much as $65 billion, depending on who you ask.

0:16 But how was that even possible?

0:18 His fraud may be all he is remembered for today.

0:22 But whether we would like to admit it or not,

0:25 he changed the landscape of modern investing in more ways than we acknowledge.

0:29 Ironically, had it not been for his Ponzi scheme,

0:32 he may be remembered even less fondly

0:35 for the other financial tools he pioneered,

0:38 like payment for order flow, dark pools, online trading,

0:42 FINRA, and the proliferation of hedge fund market makers.

0:46 But perhaps more concerningly, his crimes also tell us a lot about

0:50 the way our financial system operates to this day,

0:53 which is revealed just by asking the most logical question.

0:57 How did he think this was all going to end?

1:01 He was a veteran of the financial industry, taking money off some of the richest

1:06 and supposedly smartest investors in the world,

1:09 running an operation that by its very nature was inherently unstable.

1:13 It also raises the question of what did

1:15 his victims actually think they were investing in.

1:18 The whole system was propped up on the three pillars of obscurity,

1:24 ambiguity, and exclusivity,

1:26 which are coincidentally very common place in a lot of the biggest firms today.

1:32 Of course, nobody is saying that something like any of the several

1:36 thousand private equity funds operating in America today are a Ponzi scheme.

1:42 But the point is, if they were,

1:44 it would be very hard to find out until it was too late.

1:48 And these days, that might actually have real consequences.

1:51 Perhaps the biggest irony in the Maidoff story, though,

1:54 is that despite being one of the largest frauds in financial history,

1:58 it didn't really hurt any of its ultra-wealthy victims too badly,

2:02 at least not badly enough to enact any meaningful change.

2:05 Good old Bernie exposed a lot of flaws in our system,

2:09 and all of them were quickly glossed over as he was shipped off to prison.

2:14 Nobody wants to learn from history when there

2:16 is a profit to be made by forgetting it.

2:18 It's been 2 and 12 months since Bernard El Maidoff was picked up

2:22 and charged with what's believed to be the largest financial fraud in history.

2:26 We still don't know much more about the alleged $50 billion scam.

2:29 He was in the right settings.

2:31 He played golf at the right places.

2:33 He ate lunch at the right places.

2:35 and he went to dinner with the right people and what

2:37 he did was he was able to suck them in.

2:40 I read it and then I read it again.

2:43 It was like in shock, like nonbelieving shock.

2:46 He couldn't possibly have this isn't true.

2:49 It's impossible to be true.

2:51 He had the patina of being a respected citizen,

2:54 one of the most successful businessmen in New York,

2:56 and certainly one of the most powerful men on Wall Street.

2:59 You would never suspect him of fraud.

3:01 The beginning of Maid Off's uh

3:04 distinguished career was almost remarkably unremarkable.

3:08 He came from a financially comfortable family

3:11 and married into another financially comfortable family.

3:13 But he was still expected to get his own start.

3:16 While he was at university, he did what any student does.

3:19 He took whatever job he could get.

3:21 He worked as a lifeguard in the summers

3:23 and installed sprinkler systems in people's yards.

3:25 and he did it long enough that the paychecks

3:28 actually brought in a meaningful amount of money.

3:30 By the time he graduated, he had scraped together around $5,000 in savings,

3:34 which for a kid his age at the time was pretty impressive,

3:38 but still nowhere near start your own Wall Street firm money.

3:42 For a moment, he did the respectable thing and went to law school,

3:47 which is exactly what you're supposed to do if you want a safe,

3:51 professional career.

3:52 But he found that arguing about money was

3:55 far less interesting than actually making money because after

3:59 a year he dropped out and doubled down

4:01 on the idea of starting his own business instead.

4:04 5 grand from lifeguarding only gets you so far.

4:06 So he turned to the oldest form of seed funding and finance.

4:10 He asked his father-in-law for a small loan of $50,000.

4:15 So with roughly $55,000 in combined savings and family money,

4:19 Bernard Elm Maidoff Investment Securities opened its door in 1960.

4:23 Now at this time Bernie wasn't managing money for ultra

4:27 wealthy families or running some

4:29 mysterious hedge fund promising marketbeating returns.

4:32 He was effectively just doing the basic grunt work

4:36 of finance filling in cracks where he could find them.

4:39 In the early years, Maid Off was a market maker,

4:42 mostly in tiny companies listed on what were called the pink sheets.

4:47 Trading stocks that on a good day might only

4:49 see a handful of people actually buying or selling them.

4:52 A market maker's job is pretty simple.

4:54 You stand in the middle of other people's trades.

4:56 You post a price you're willing to buy a stock

4:59 at, and you post a price you're willing to sell it at.

5:03 The margin between these two numbers is how you make your living.

5:06 If somebody wants to sell quickly, they take your lower bid.

5:09 If somebody wants to buy quickly, they pay your higher offer.

5:12 And the gap in the middle, known as the spread,

5:15 is where you get paid for providing this liquidity.

5:18 If you've ever flipped items in Runescape or Eve Online for a profit,

5:23 you have effectively done what Maidaf was doing for the first few years

5:27 of his career on a big exchange with tight regulations and lots of competition.

5:31 This is a boring, low margin way to make a living.

5:36 Spreads are typically small, information is widely available,

5:39 and the system at least pretends to be fair.

5:42 The pink sheets were not that.

5:44 This was the part of the market where small, obscure,

5:48 and sometimes questionable companies ended up when they

5:51 couldn't meet the standards of the main exchanges,

5:54 which meant fewer buyers, barely any regular trading,

5:57 and almost no reliable information for anyone to work with.

6:01 The name itself came from the daily pricing updates that the National

6:05 Quotation Bureau would send out every day on cheap pink printer paper.

6:08 And the fact that stock prices in these companies were only updated once a day

6:14 should really tell you all you need to know about these kinds of operations.

6:18 Prices in that world could be nudged around by a few aggressive brokers,

6:21 a couple of phone calls, or a sales script that sounded convincing enough

6:25 to someone who didn't know what they were buying.

6:27 For comparison, share prices on modern, large,

6:30 and well- reggulated exchanges can often be updated by millions every second.

6:35 So, this kind of stock trading really was a different game.

6:39 Of course, the name Pink Sheets may

6:41 sound familiar to you because there was another

6:44 infamous financial swindler who got his start

6:47 doing the same thing about two decades later.

6:50 Name of the company, Aerotine International.

6:52 It is a cuttingedge high- techch firm

6:55 out of the Midwest awaiting imminent patent approval

6:58 on a next generation of radar detectors

7:01 that have both huge military and civilian applications.

7:04 Now, to be clear, not everyone operating

7:06 in this space was running a full-blown scam.

7:09 But even the most honest players were working with a certain

7:13 level of sleas that was just baked into the business model.

7:16 When you are the one posting the only

7:19 real prices in a dark market that barely trades,

7:23 you can quietly widen the spread,

7:26 treat unsophisticated retail clients a little worse than your friends,

7:30 or lean on information you got a few seconds before everyone else,

7:34 and most of the time, nobody will ever know.

7:37 This was the world Bernie Maidoff learned in.

7:40 Not a clean, well-lit trading floor with cameras,

7:43 but the gray zone of the pink sheets,

7:45 where prices were flexible, rules were fuzzy,

7:48 and nobody looked too closely at how the money was actually being made.

7:53 But a system like that was never going to stay invisible forever.

7:57 Normally, this is where you'd expect the state to step

8:00 in with a thick rulebook and a regulator nobody can afford to ignore.

8:04 But rather than building a powerful watchdog,

8:06 the solution was effectively to hand the leash to the dog and say,

8:11 "Well, you seem responsible.

8:12 Why don't you just supervise yourself?" The result was

8:16 the National Association of Securities Dealers or the NASD,

8:21 a self-regulatory organization set up so

8:23 that brokers could effectively write the rule book, enforce it on one another,

8:29 and then present the results to the public as investor protection.

8:33 On paper, the NASD was there to license brokers,

8:37 inspect firms, investigate misconduct,

8:39 and make sure that the kind of pink sheet shenanigans

8:42 we just talked about didn't get completely out of hand.

8:45 Over time, that structure was reshuffled and rebranded.

8:49 The NASD's regulatory arm was merged with bits of the New

8:53 York Stock Exchange's own enforcement division

8:55 and the combined entity became FINRA,

8:57 the Financial Industry Regulatory Authority,

9:00 the main organization that is supposed to keep

9:03 American broker dealers in line to this day.

9:06 Whether or not it actually does is a problem we'll get into later in the video.

9:11 But for now, know that Bernie Maidoff was

9:13 not some nervous outsider at odds with this system.

9:16 His firm was a major member.

9:18 He sat on NASD committees.

9:20 He was treated as a model operator.

9:23 Exactly the kind of seasoned insider you ask for input

9:26 when you're deciding how strict those rules should actually be.

9:29 So, the guy who learned his craft in the gray

9:33 zone of the pink sheets didn't just survive the cleanup.

9:36 He helped shape the body that was doing the cleaning.

9:39 But even with that new respectable layer of regulatory involvement,

9:43 he was still at the end of the day a broker competing

9:47 for business against firms that actually had seats on the big stock exchanges.

9:52 The traditional way to do that was to be on the floor yourself,

9:56 jacket on, paper in hand,

9:57 standing in a crowded room of sweaty men shouting orders at one another

10:01 and trying to get the attention of whoever was closest to the book.

10:05 Instead of trying to win by shouting over everyone on the floor,

10:08 Maidoff started leaning heavily on computers to root

10:11 and match orders instead of relying on runners, hand signals, and phone calls.

10:16 Now, give credit where credit is due.

10:18 This was genuinely quite visionary.

10:20 Back when computers still looked like

10:22 this, he was already looking at the trading

10:24 floor and deciding he'd rather have a screen to handle those conversations.

10:28 Instead of throwing his orders into the chaos of the trading floor,

10:31 he built systems that could quietly take in client orders,

10:35 match buyers and sellers automatically,

10:37 and send back confirmations without all of the theater

10:41 that went along with the traditional trading floor.

10:43 This approach didn't just make life easier for his clients.

10:47 It quietly turned his little brokerage into something

10:49 that behaved a lot like a mini exchange.

10:52 Orders came in, trades got matched,

10:55 prices were quoted on screen instead of shouted across the room.

10:58 And while all of this was happening, the NASDA was trying to work out what

11:03 the future of stock trading would look like.

11:05 They saw that the old model of colored

11:08 jackets and hand signals wasn't going to scale forever.

11:11 And they saw that what Maidoff was doing looked

11:13 a lot closer to where the industry was headed.

11:16 So when they decided to build a market for its

11:19 members that didn't rely on a physical trading put at all,

11:23 they went down the same path,

11:25 creating an electronic system that would publish quotes,

11:28 match trades automatically,

11:29 and let brokers plug in through their terminals instead of their vocal cords.

11:34 They called it the National Association

11:36 of Securities Dealers automated quotation system,

11:39 mercifully known more commonly and simply as the NASDAQ.

11:43 Over the next few years,

11:45 this screen based market stopped being a side project and quietly turned

11:50 into one of the main ways trades in American stock were actually getting done.

11:54 And Maidofff's firm was doing a large amount of the volume on Wall Street.

11:58 Bernard Elm Maidoff Investment Securities was

12:01 routinely handling orders for big institutions.

12:04 And the man who started out matching

12:06 trades in obscure pink sheet companies was now

12:09 presented as one of the people who understood

12:12 the new electronic Wall Street better than most.

12:16 Inside the NASDAQ world, his name was everywhere.

12:20 He held senior positions, sat on committees, and in the early 1990s,

12:24 he even served three one-year terms as chairman of the NASDAQ stock exchange.

12:30 He was the man that stock brokers put forward

12:34 to reassure people that the market was in safe, experienced hands.

12:39 Anyways, this is where the issue with self-regulation started to become obvious.

12:43 Groups like FINRA and the exchanges

12:46 were introduced as guardians of market integrity.

12:48 But they were also industry clubs founded

12:50 by member firms and staffed by people who

12:54 moved back and forth between the regulator

12:56 and the regulated often within the same business day.

13:00 Politically, it's sold as a win-win.

13:02 It's cheaper for the taxpayer than building large

13:06 independent public regulators and actually funding them properly.

13:09 And it sounds efficient because the people writing the rules

13:12 supposedly understand how money works better than anyone else.

13:16 In practice, even beyond the obvious problem of self-regulation,

13:20 it creates other more subtle weaknesses.

13:23 New firms and smaller players trying to do everything

13:27 unconventional get put under the microscope in excruciating detail.

13:31 While big long-standing members that generate

13:33 enormous volumes and fee income tend

13:36 to be treated with a lot more patience and understanding, firms like Madoff.

13:41 Now, to be fair to everything we've talked about so far,

13:45 this is still the legitimate half of the Bernie Madoff story.

13:49 The market making, the clever use of computers, the roles inside NASDAQ,

13:53 none of that on its own is the Ponzi scheme.

13:57 The uncomfortable part is that when you look at how his actual scam worked,

14:02 the secrecy, the exclusivity,

14:03 the lack of real oversight behind a very respectable public facade,

14:08 you start to see patterns that look a lot less like a one-off crime

14:11 and a lot more like a template

14:13 that still exists in parts of modern finance today.

14:16 So, it's time to learn how history works.

14:18 to look at how a supposedly safe, boring,

14:22 well-connected firm managed to bolt a Ponzi scheme onto

14:26 the side of its real business and why the ingredients

14:29 that made that possible are still very visible in some

14:31 of the most fashionable investment structures operating right now.

14:34 When you look at the Bernie Maidoff story,

14:37 the most interesting part is not just the fraud itself,

14:40 but how long it went unquestioned.

14:43 Smart people, sophisticated institutions,

14:45 and regulators all missed the warning signs.

14:48 That kind of failure is less about intelligence and more about how we reason,

14:53 test assumptions, and evaluate evidence.

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15:26 have raised red flags in cases like maid off.

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16:17 madoff's actual scam sat off to the side of all

16:20 of this in what was officially called his investment advisory business.

16:24 Basically, his asset management arm.

16:26 This was the part of the firm that promised

16:30 clients 10 to 20% returns regardless of market conditions.

16:35 Now, anyone who knows the first thing about market

16:39 returns will know that this is obviously just impossible.

16:43 But crucially, madoff was very selective about who he let in.

16:47 You couldn't just fill out a form, wire money, and invest in his fund.

16:51 You got introduced through a private bank, a charity board,

16:54 or a friend at an exclusive golf club.

16:57 That selectivity did a lot of heavy lifting.

17:00 If access to something is scarce and everyone around you is impressed

17:04 you're in, you are far less likely to start asking annoying questions like,

17:08 "Where exactly is this money going?" or "Can I see the trades?"

17:13 Maid off told people he was running a relatively conservative option strategy,

17:18 buying a basket of large,

17:20 well-known stocks and then using options to hedge the downside,

17:23 which for anyone who didn't want to get into the weeds,

17:27 sounded sophisticated enough to be plausible and safe enough to be comforting.

17:32 Clients got statements showing a neat staircase of positive monthly returns,

17:37 very little volatility,

17:39 and almost no visible connection to what the broader market was doing,

17:42 which should have been a giant red flag,

17:45 but instead became part of the sales pitch.

17:48 Behind the scenes, there was no complex strategy.

17:51 In most cases, there were no real trades at all.

17:54 New money came in, old investors who wanted to withdraw paid out,

17:58 and whatever was left sat in bank accounts,

18:01 while the back office produced fake trade confirmations

18:04 and account statements to keep everyone feeling calm.

18:07 At one point, there was something like $5 billion

18:11 just sitting in a regular JP Morgan bank account,

18:15 not tucked away in some exotic offshore structure,

18:18 just parked in plain sight because nobody was really looking.

18:22 I almost wish there was some more technical deception behind

18:25 the scenes to make it sound more interesting for the video,

18:28 but that really was all there was to it.

18:30 The only real cunning was in how he

18:33 presented himself and his firm to supposedly sophisticated investors.

18:36 But in that regard, there are still a lot of uncomfortable

18:41 lessons that we have not learned from the Maidoff story.

18:44 Now, obviously, most modern investment firms

18:47 are not running literal Ponzi schemes,

18:49 and it would be ridiculous to say that every

18:52 private equity fund is just made off with a PowerPoint.

18:56 But once you see how his operation actually worked,

18:59 it's hard not to notice a few uncomfortable similarities.

19:03 Today, when people talk about alternative assets,

19:07 they're usually talking about some version of the same basic idea.

19:11 raise a large pool of capital, buy real companies using a lot of borrowed money,

19:15 tinker with the business for a few years,

19:17 pay down some of the debt, and then sell the whole thing on for a higher price.

19:22 The brochure version goes something like this.

19:25 A fund buys a company, professionalizes management, cuts unnecessary costs,

19:30 maybe nudges revenue higher, uses the extra cash flow to pay down the debt,

19:35 and then exit at a better valuation because

19:38 the business is supposedly healthier than it was before.

19:41 There is nothing inherently illegal about VATS,

19:43 and in plenty of cases, it does exactly what it says.

19:47 But it is a little strange that an entire industry

19:50 can print very strong returns for long periods of time,

19:54 mostly by refinancing balance sheets, shaving expenses,

19:58 and passing the same assets from one fund to another.

20:01 A lot of the performance in the middle is very hard to measure from the outside.

20:07 Portfolio companies are private.

20:09 Valuations are based on internal models.

20:11 numbers only get updated a few times a year and there

20:16 is no daily market price shouting at you when something goes wrong.

20:20 You see a smooth line of reported returns,

20:23 but you don't really see the path the companies took to get there.

20:27 The exit routes make this even harder to ignore.

20:30 A huge share of portfolio companies aren't

20:33 sold to public markets or long-term industrial buyers.

20:37 They're sold to other private equity firms that have

20:40 just raised fresh capital and need somewhere to put it.

20:43 One fund buys the business, pays down some debt, claims improvement,

20:48 then passes it on at a higher multiple to the next fund,

20:52 which might do exactly the same thing again a few years later.

20:57 This does not make private equity a Ponzi scheme.

21:00 The industry will be quick to point out that there are real assets,

21:04 real employees, real cash flows.

21:06 But at the same time,

21:09 an industry like multi-level marketing will similarly claim they

21:12 are not a pyramid scheme because they sell real products.

21:17 The broad reality for private equity as an industry

21:19 is that over the last decade in particular,

21:22 a lot of the impressive predictable headline

21:25 returns depended on new investor dollars coming

21:29 into the system at higher entry prices

21:31 so that the existing investors could cash out.

21:35 Yes, there are more moving parts and actual businesses involved,

21:38 but if the whole system is still reliant on new investors piling in, I mean,

21:44 what would you call that?

21:45 Now, maybe you still think it's different enough, and that's fine.

21:49 But we've also made this much harder

21:51 to monitor by putting it behind a regulatory wall.

21:54 These funds only deal with institutions

21:57 and sophisticated high net worth clients,

22:00 which means lighter disclosure, fewer reporting requirements,

22:04 and a general attitude from watch dogs of, well,

22:07 they should have known what they were getting into.

22:10 If you're a retail broker calling someone about

22:13 a few thousand dollar worth of listed stocks,

22:17 FINRA will happily make you sit exams,

22:20 get licensed, and live under a detailed rule book.

22:23 But if you're structuring billion dollar buyout

22:26 deals for teacher pension funds and family offices,

22:29 most of what you do sits outside of FINRA's licensing regime

22:33 entirely simply because you're not technically

22:36 selling securities to the general public.

22:38 You see a similar pattern in private credit which has grown

22:42 into a kind of shadow banking system alongside all of this.

22:46 Bespoke loans made by funds and direct

22:49 lenders negotiated in private with light covenants.

22:53 Optimistic assumptions about downturns and positions that are

22:56 marked to internal models rather than any real market.

23:00 As long as the cycle cooperates, everything looks fine on paper.

23:05 Yields are collected.

23:06 New investments keep flowing in, marks are gently nudged upward,

23:09 and nobody outside the inner circle has much

23:12 visibility into the actual risks building up underneath,

23:16 which means frauds and bad bets can sit there undisturbed for a very

23:22 long time before anyone realizes how big the hole really is.

23:26 None of this is to say that private equity

23:30 or private credit is just made off in disguise.

23:33 The point is that we are still very

23:36 comfortable with financial structures that are exclusive, opaque,

23:39 lightly supervised, and extremely hostile to anyone who

23:43 wants to take a proper look under the hood.

23:47 And those are exactly the conditions which allowed Maid Off's

23:51 very simple fraud to survive as long as it did.

23:55 In Maid Off's case, the irony is that the headline number everyone remembers,

23:59 you know that $65 billion, well, it was never real in the first place.

24:03 That figure came from fake account statements and imaginary compounding,

24:07 not from actual cash that went into the system.

24:10 If you look at the money that actually went in, it

24:13 was somewhere in the ballpark of 18 to 20 billion of principal.

24:16 And after the dust settled, the trustees managed to claw back and distribute

24:21 something like 15 billion of that to his investors.

24:24 Which means that on aggregate, this once in a century fraud destroyed

24:29 far less real wealth than the headline suggests.

24:32 And most of the people involved were still comfortably rich afterwards,

24:36 just slightly less rich than they thought they were on paper.

24:40 The biggest irony of all of this though

24:42 is that because his scheme fell apart in 2008,

24:45 it was actually a better investment than

24:47 a lot of other investment firms on Wall Street.

24:51 Being in an outright Ponzi scheme run by Bernie Madoff meant only losing about

24:57 20% of your money at the time when plenty of totally legitimate hedge funds,

25:03 structured products, and bank balance sheets were blowing up entirely.

25:07 Obviously, that doesn't make it right.

25:09 A fraud is still a fraud, but it does underline how broken the wider system was.

25:14 You could be in a complete lie and come out

25:18 better than people who trusted products that were supposedly regulated,

25:22 transparent, and run by some of the most respected names on Wall Street.

25:26 And back then, most of the damage was

25:29 contained to a fairly narrow slice of wealthy individuals,

25:32 charities, and institutions who had chosen voluntarily to play

25:35 in that exclusive little corner of the market.

25:38 Ordinary households didn't wake up one morning

25:41 to discover that their job, their home,

25:43 and their pension were all secretly depending

25:46 on whether Bernie Madoff could keep finding new money.

25:49 Today, we may not be so lucky.

25:51 A modern private equity fund still only takes money

25:54 from rich clients and big institutions on the surface,

25:57 but underneath that, a lot of those institutions

26:00 are gambling with our retirement savings,

26:03 which they use to buy up companies with real workers,

26:06 real customers, and very real obligations to the communities they operate in.

26:12 The same goes for private credit.

26:14 Those alternative lenders are not just swapping paper with one another.

26:18 They are deciding which businesses can roll their debt,

26:22 which property developers can finish projects,

26:25 and which firms have to start cutting staff when the next downturn shows up.

26:30 If a system like that ever suffered a madoff sized honesty problem,

26:35 or even just a prolonged period where everyone simultaneously

26:38 realized the values they were throwing around were nonsense.

26:42 The fallout wouldn't be a few

26:44 embarrassed rich people quietly downsizing their yacht.

26:47 It would mean layoffs, shuttered factories, unfinished housing projects,

26:51 and pension funds scrambling to plug holes that nobody thought existed.

26:57 In other words, we've rebuilt many of Madoff's favorite conditions, obscurity,

27:02 ambiguity, exclusivity,

27:04 and very light scrutiny for anyone dealing with sophisticated money.

27:10 But this time, we've wired those conditions

27:13 directly into the plumbing of the real economy.

27:16 That's the part of the story that should worry us

27:19 a lot more than the cartoon headline about $65 billion.

27:22 The mechanics of this scam were simple, almost boring.

27:26 The environment that let it run for decades is

27:29 what matters because that environment never really went away.

27:33 It just moved into new products with better branding.

27:35 And if you zoom out even further,

27:38 you realize that none of this is especially new.

27:41 dressing up simple lies in complicated language,

27:44 hiding risk behind social status, leaning on trust instead of verification.

27:49 Humans have been doing that for as long

27:52 as we've been swapping anything of value.

27:54 Maid off wasn't some glitch in an otherwise perfect system.

27:58 He was one very flashy example in an 8,000-year tradition of people

28:03 discovering that if you mix a good story with enough opacity,

28:08 you can separate other people from their wealth for an impressively long time.

28:12 So, if you want to see how deep

28:15 that tradition really goes from ancient merchants and medieval bankers,

28:18 and maybe get a better sense of what the next version of this will look like,

28:22 go and watch our video on the 8,000-year history of scams.

28:25 And don't forget to like and subscribe to keep on learning how history works.