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.

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