Bernard Madoff and Ponzi Schemes--Posner's Comment

I must be cautious in discussing the Madoff scandal because as a judge I am forbidden to make a public comment on pending or impending litigation. Madoff himself of course has been arrested, and already lawsuits have been filed against some of the "funds of funds" that steered investors' money to him. I shall proceed on the assumption that the media are correct in describing Madoff as the author of a Ponzi scheme--indeed he is reputed to have described it that way himself--but I shall treat it strictly as an assumption, a hypothesis, and not as established fact, which is for a court to determine. And I will not comment at all on the suits against the funds of funds. It is unsurprising that a Ponzi scheme should come to light during a stock market crash. As Warren Buffet is reputed to have said, one doesn't know who is swimming naked until the tide runs out. The stock market crash would have reduced any remaining assets in Madoff's investment account at the same time that liquidity problems caused by the depression would have increased the rate of redemptions. Madoff's scheme, as described in the media (and remember that I am not taking a position on the truth of any of the allegations that have been made against him), is not a classic Ponzi scheme. The classic scheme is a "con" in the sense of a fraud perpetrated against greedy dopes. A skillful con man uses his gift of salesmanship to inveigle people by such ludicrous pitches that only the least sophisticated, or those most blinded by greed, are conned. A typical Ponzi scheme might offer a 10 percent monthly return on investment--the very improbability that such an offer could be genuine assures that only suckers will invest and they are least likely to discover that they have been conned until the con man has made a bundle. They may never discover that they have been conned--they may be convinced by the con man that they lost their money because of a legitmate business failure. Or they may be embarrassed to complain, or even afraid to complain because they suspect that they've been involved with a criminal enterprise--what but a criminal enterprise could generate a 10 percent monthly return on one's investment? It is possible therefore that many Ponzi schemes are never reported to the authorities and hence never detected. The strategy that has been attributed to Madoff is the opposite of that of the typical Ponzi schemer: it is to obtain investments from well-off people far more financially sophisticated than the average Ponzi victim, including genuine financial experts such as hedge fund managers and bank officials. And therefore it requires different tactics from that of the ordinary Ponzi scheme, such as offering returns only moderately above average, satisfying redemption requests promptly, turning down some would-be investors (it would be interesting to know whether there was a tendency to turn down investors who might prove nosy or suspicious), and trading on a reputation earned in a legitimate business (Madoff's business of market making). Madoff is alleged to have preyed primarily on his fellow Jews; such "affinity" frauds are common, because people are likely to be more trusting of members of their own ethnic or religious group than of outsiders and because a con man may be abler to identify and exploit the weaknesses of members of his own group than of others. The most interesting question raised by the scandal is why though it apparently continued for decades it was never detected by the Securities and Exchange Commission, even though beginning eight years ago a money manager named Harry Markopolos began bombarding the Commission with letters accusing Madoff of operating a Ponzi scheme. (The fact that Madoff did not sue Markopolos for libel should have been another warning sign.) There are two hypotheses. One is that regulation is hopelessly inefficient, and that it should be up to investors to protect themselves as best they can against securities frauds. The SEC's budget was increased substantially in 2004 in reaction to its failure to have detected the Enron, World Com, and other financial scandals that erupted in the early years of the new century, yet it still failed to detect Madoff's scheme. The other hypothesis is that under Chairman Christopher Cox (as under the first chairman appointed by President Bush, Harvey Pitt), the SEC has been too trusting of the securities industry, as part of a general philosophy of deregulation, small government, and laissez-faire that has characterized the Bush Administration. The SEC does seem to have been asleep at the switch quite a bit of late. Just days before the collapse of Bear Stearns marked the beginning of the banking crisis, Chairman Cox said that "We have a good deal of comfort about the capital cushions at these firms at the moment." In fact most of the firms about which he was speaking--the investment banks--were teetering at the brink, and in some cases over the brink, of insolvency. Cox's reaction to the Madoff scandal has been to blame his subordinates in the Commission, rather than to take responsibility himself. That is not an endearing reaction. The standard governmental response to a major governmental failure is reorganization. The government wants to prove that it is doing something to prevent a repetition of the failure, and the cheapest yet most visible and dramatic way to show that it has "gotten the message" and is going to "do something" is to reorganize. Hence the creation of the Department of Homeland Security and the Directorate of National Intelligence in the wake of the 9/11 attacks. It is beginning to seem likely that there will be an ambitious reorganization of the financial regulatory system. In the course of that reorganization, the SEC may be abolished. If so, Bernard Madoff and Christopher Cox can share the credit.

Comments

[Anonymous]

I lay a large chunk of it on the Congress's and the federal courts' urge to pre-empt - not just expressly but via supposed implied conflicts - state regulation of securities issuers, underwriters, fund managers, and investment advisors. What type of financial contract can the purchaser - wealthy or of moderate means - still have confidence in? Chances are it's a policy issued by a state-regulated insurance company. Long live the McCarran-Ferguson Act.

[UCD Neuroscientist]

The SEC has indeed been alseep at the switch. An important component of the SEC's mandate under the Securities Act of 1933 is disclosure (investors should receive sufficient information concerning securities being offered for public sale). In my opinion, there isn't sufficient disclosure for many new investment products to allow an investor to make an informed investment decision. Hedge funds and investment pool's like Madoff's represent glaring example. However, there are many other examples of products that seem to have fallen through the cracks. Even seemingly safe money funds have insufficient disclosure. I have warned the SEC repeatedly that tax-exempt money market funds are an accident waiting to happen. These funds generally invest in variable rate demand notes that are complex products, which ultimately rely on a bank letter of credit as a guarantee. The specific securities that these funds hold are not described in sufficient detail. Most funds don't disclose the remarketing arrangements and banks that are integral to the products. A fund manager reaching for yield could easily fill their fund with VRDOs backed by lower quality banks, and nobody would be the wiser. If such a fund 'broke the buck,' this would trigger a run on the entire industry that would bring the banking system down. This occurred in the case of taxable money funds in September when the Reserve Fund broke the buck, requiring the Fed to backstop the industry. It has been very frustrating that the SEC has turned a deaf ear. It seems that they have given up trying to keep up with the new investment products. Regrettabley, as Judge Posner suggests, it may be necessary to completely reorganize -- or even abolish -- the SEC.

[Michael Webster]

1. There is no such thing as a typical Ponzi scheme. You are mistaken to think that Madoff's pitch was any different than Charles Ponzi's pitch. Both knew their audiences very well. Ponzi knew that the Italian immigrants who had saved pennies would respond well to fabulous claim; but in the context of 1919 these rewards were not too good to be true. Madoff, on the other hand, knew his audience was risk adverse, so he promised a non volatile return.

2. Again, you misunderstand the regulator's function. The regulator never shuts down a Ponzi scheme until there are sufficient complaints, documented losses, and a clear fraud. No investor complained about Madoff. Nobody. Not a single investor complained. No regulatory scheme that we have set up to date can deal with this problem. (The fastest shut down of a Ponzi scheme was a 3 -4 months after launch, a Brazilian affinity fraud in Boston.)

3. The original Charles Ponzi used to "lend" money to high placed people, bank officers, police, newspaper reporters, and "invested" the loan in his Securities Exchange Inc. This is exactly the same method Madoff used in employing hedge fund of funds. He offered them a straight commission for the feeder investments: these hedge managers were no fools, they took their guaranteed 2/20 and will now make noises about how they were "fooled" by the sophistication of Madoff.

I have written a number of articles concerning behavioral economics, the psychology of fraud, and ponzi schemes which may interest your readers.

http://www.bizop.ca/MT-4.21-en/mt-search.cgi?blog_id=1&tag=Bernard%20Madoff&limit=20

[nathan]

see Mark Cuban's blog on SEC

[Anonymous]

Given the very detailed complaint from November 7th 2005 to the SEC no-action by the SEC is a crime itself and I doubt that investors will continue to have faith in the us capital markets and it's regulators if government does not clean up this mass. In my view the government has become liable and a lawsuit should be filed against the SEC. GL Austria

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[Daniel]

@Michael Webster

You have got to be kidding about no investors complained. The SEC has been on notice about Madoff for years.

Also, you have got to be kidding about the SEC only investigating complaints. The deregulators saw the SEC "just" as a consumer complaints bureau, but what you (and others) seem to have missed is that the SEC has the responsibility to proactively ensure the proper functioning of securities markets -- by among other things requesting information of market participants.

I know, it sounds so quaint. But that's what regulators are supposed to do, when they're working. Instead, we got the regulators we paid for.

[Andy]

I agree that the SEC should have discovered this earlier. That's why it shouldn't be a government entity, but rather a private rating and approval agency like Moody's, UL or Consumer Reports, competing with others in its field. That way, if it becomes lax, then people no longer value the "fund approved by SEC" mark, which means companies have no incentive to get that mark on their investments, which means the hypothetical private-SEC loses money.

Its hypothetical strict competitor, who did more proper diligence and refused to certify Madoff, would gain public trust and many people wouldn't invest in something not approved by it. This means companies would gladly pay to get the certification, and the SEC-competitor would profit.

It wouldn't be perfect, as we've seen by the failure of the private rating agencies to mark nearly-insolvent companies down to their appropriate rating, but I still trust market incentives more than an unaccountable political appointment that shifts every 4 years. Cox doesn't need to worry about getting fired for incompetence if he's going to get fired anyway because a new president is elected.

[Dan]

A third hypothesis, Your Honor: corruption at the SEC.

[Richard]

This may be different in degree from other Ponzi schemes but not, it seems to me, in kind. It appears to fit the basic definition, i.e., that funds from new investors are used to pay off earlier investors, rather than being invested.

I don’t know that Buffet’s swimming-naked metaphor applies here in the same way it applies to risky-but-legitimate investments. Perhaps the recession cuts back on the additional funds that new investors can put into the fund. That would help expose the fraud. But Buffet was referring to a decrease in the value of existing assets in a fund. But if it’s a Ponzi scheme and there never were any assets, then that wouldn’t drive the situation.

[bbartlog]

In the course of that reorganization, the SEC may be abolished

Yes, because Washington DC is always eliminating failed bureaucracies. Give me a break. They'll keep the (mostly useless) SEC and just use these events as an excuse to create yet another TLA agency with the usual set of people who couldn't find work in the private sector. You'll notice that we still have FEMA, the INS, and the Department of Education despite their colossal failures.

[Joe Mack]

These funds were not registered for sale to the public and not covered under the 40 act, so the SEC probably doesn't have anything to do with this. Right?

[gdgeiss]

Interesting post by M Webster and comment on it by Daniel.

With all due respect, Webster, I believe, said no INVESTOR of Madoff's complained. Hell, why should they? Until recently, they were all making a nice comfortable 10% return thru thick and thin.

The complaint(s) came from a COMPETITOR, a hedge fund manager, who couldn't match Madoff's returns and complained, therefore (based on his back testing models of the "supposed" Madoff stategy), that nobody legitimately could. If an important client of Madoff's had squawked, the SEC might have done something more than glanced in his direction. But a competitor? Easily dismissed, especially when directed against a "pillar" of the investment community, a universaly well liked and well respected guy. A champion of charitable giving, a market maker without any prior taint of corruption. I'm guessing that if the SEC followed up every cry of "foul" made by a disgruntled competitor, they'd do nothing else.

Hindsight is always 20/20. The SEC, in hindsight, is a cheap target.

Now, I agree it's a deeply flawed agency, as are many regulatory bureaucracies, but not so much because they missed Madoff, as because of the way they habitually do business, regardless of what administration is in office and who's head bureaucrat. They, like so many others, are run by and (in important spots, anyway) are made up of guys once from and intending to return to the private sector they're supposed to be regulating. They all, frankly, have built in conflicts of interest.

Madoff himself, I'm afraid, seems to be just another harbinger of the the same diseases as spawned the rest of this stinking financial and economic disaster: greed and arrogance.

[Anonymous]

Since it's soooooo much different, we can call it a Pozner Scheme.

[michael webster]

@ Daniel,

I think that you have misunderstood my remarks. I intended to respond, but see below.

@ gdgeiss,

Thank-you for pointing out a number of reasons why the SEC didn't respond to the Markoplos complaint, which can be read here:

http://www.scribd.com/doc/9189285/Markopolos-Madoff-Complaint

I think that the complaint is poorly drafted, in the sense that it is not designed to engage the regulator's mind.

Had Mr. Markopolos claimed and documented that a number of the feeder hedge funds were not disclosing to their clients that they were fully invested in Madoff, there might have been a different response.

Prior to Madoff, the complaints about the financial industry could be summarized as the quants having an inadequate theory of risk.

After Madoff, we now see an industry willing to engage in criminal conspiracy, siphon wealth and destroy the base of capitalism. This is very troubling.

[SA]

An investor has no incentive to blow the whistle _if_ he is able to extract his funds from the scheme. Madoff over the years honored redemption requests, so there was no injured party to complain to the SEC. Blowing the whistle would only make it probable that the knowing investor would have to surrender his returned funds to the receiver.

[BCCM]

This has been a very interesting story and I wonder which one of you wrote what sounds more like a legal opinion; laying a pathway for what I don't know. I don't find the notion that the conduct is not a classic ponzi scheme because it involves white collar activity rather than blue collar activity credible.

You say: (The fact that Madoff did not sue Markopolos for libel should have been another warning sign.)The reason Madoff does not sue is because the burden of proving the libel is on him or he has to disprove the untruths exposing himself to further liability beyond his ability to pay.

http://www.bccmeteorites.com/misconduct-planetary.html

[BO Bill]

I’d like someone to explain to me the difference between the Madoff scheme and the Congress scheme, other than three zeros.

[Critic]

When an individual sets up a Ponzi scheme we call it a crime (and it is); when the government does it we call it Social Security.

[Jack]

Critic: Interesting that you bring up SS. About 20 years ago Sen Moynihan and some others worked together to make SS a viable equation well into the future, including that of funding the retiring boomer generation. So what happened?

We'll SS is not yet a basket case, but in those same 20 years median income stopped increasing. Yep, that "rising tide" of JFK that was supposed to "lift all the boats" quit lifting MOST of the boats. Now it's true that AVERAGE per capita income has continued to rise, but the average is hauled upwards by incomes higher than the $90,000 at which SS contributions are clipped off.

So........ the increase in contributions projected by Moynihan & Co have not lived up to expectations.

SS can be fixed, but perhaps what is worse is that the flat median wage ($50k per household) offers virtually NO chance for those at or below median to save for their own retirements, so it is hardly a time to give up on SS.

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[Bill Dugan]

I don't see the relevance of this BLAWG entry? What does Posner have to add to the mix. We want to know what is really going on and if this yutz is not involved in the case, he is really no brighter than any other yutz. I suggest we get some insight from a lawyer involved in the investigation.

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[neilehat]

Jack, The "Critc"s" comment is but a rhetorical ploy by a Libertarian advancing the policies of Anarcho-Capitalism in their attempt to destroy the Nation and it's people. Guess what that's called?