The Madoff Ponzi Scheme-Becker

The recently exposed Ponzi scheme by Bernard Madoff is named after Charles Ponzi, an immigrant to the United States, who ran his swindle in 1920, based supposedly on profits from postal reply coupons. He took in a great deal of money for those days that was partly spent on high living. After less than a year he was exposed by a newspaper, and spent many years in jail before being deported back to Italy. In a Ponzi scheme, investors in a fund typically receive good rates of return on their investments for a while because they are paid with new monies that are invested in the fund. Even when such funds do not make bad investments, or when managers do not spend a lot on themselves and their families, Ponzi funds must attract new investors at a rapid rate in order to pay good returns to prior investors. With wasted spending and bad investments, the required growth rate in new monies is even higher. Since high growth rates of new investments are hard to maintain over time, eventually Ponzi funds collapse. Then comes the day of reckoning as investors are shocked to discover that they have been duped, and have lost most or all of what they invested. Ponzi-type swindles probably go back to Greek and Roman times Over 50 years ago I had a wealthy uncle who invested with an individual who seemed to be doing remarkably well with a secretive investment strategy: he paid high returns in the form of monthly dividends, and allowed people to withdraw their investments. My uncle not only increased his investment, but advised other family members and friends to do the same (my father was either smart or lucky enough not to do so). After a couple of years the manager vanished, and investors lost all they had given him. It turned out that he was paying these good dividends not from returns on his investments, but from the new funds he was raising- a typical Ponzi scheme. While he did not lose most of his considerable wealth, my uncle went into a year-long depression after he found out he had been "taken". What was unusual about Madoff's swindle is that it continued for over two decades, and was the largest Ponzi scheme ever uncovered, with perhaps $50 billion lost or missing. It was also the first fully international Ponzi scheme, with investors from Europe, the Middle East, and China, as well as mainly from the US. One hedge fund, the Fairfield Greenwich Group, put over $7 billion into Madoff's fund, and encouraged others to invest in it as well. Bernard Madoff is a 70 year old apparently affable but retiring, person who did not live especially lavishly. He was very active in Jewish circles, so that, many of his investors were wealthy Jews, such as Jeffrey Katzenberg, Steven Spielberg, and Mortimer Zuckerman, and Jewish organizations, including the Eli Weisel Foundation and Yeshiva University. The enormous scope of Madoff's swindle raises two obvious questions 1) how could this scheme go on for so long without being exposed, and 2) how could so many sophisticated individuals be taken in by a fund that provided almost no information on how it was able to achieve consistent returns of from 8-13 per cent for many years during both good and bad times? In regard to the first question, various hedge fund managers were puzzled by how Madoff could make such consistently high returns with the information provided about what he did. Apparently, one claim was that he placed both put and call options on say the S&P 100 index. That might make money when stocks are falling rapidly, but the fund should have lost money on average during the mainly good years of the scheme's existence. One former hedge fund manager, Harry Markopolos, reported him for a decade to the SEC and also to state regulatory bodies. The SEC conducted some rather superficial investigations, but nothing much came of them-the SEC is now looking into why the swindle was not discovered much earlier. I believe this is another illustration of what has happened frequently, namely, that regulators too get caught in the hype surrounding an investor, or the economic viability of different banks. Of course, it is well documented that after a catastrophic event, many "obvious" signs are discovered that if taken seriously could have prevented the event. For example, after 9/11 it was revealed that the FBI did not investigate carefully warnings that some major terrorist act was being planned. This was also the case with the Japanese attack on Pearl Harbor. Roberta Wohlstetter in her outstanding book, Pearl Harbor: Warning and Decision, explains why the Japanese plan to attack Pearl Harbor was not discovered despite the considerable prior intelligence about their plans for an attack. This is also the case with the Madoff swindle, which makes it more puzzling. Why did many sophisticated individuals, funds, and other organizations entrust so much money to his management, and to management by various intermediaries, without doing any significant amount of due diligence? Part of the answer is that these individuals are not sophisticated in financial matters, and each successive set of investors assumed that previous investors had done some investigation. This led to an example of "information cascades", where private information is revealed sequentially over time to different individuals. Later participants can be badly misled if the information of earlier participants is far from accurate. Moreover, Madoff had developed an outstanding reputation. He was a respected member of the financial community and exclusive social circles, and a former president of the Nasdaq Stock Market. He helped pioneer electronic trading of stocks, and continued this profitable stock trading business while independently building up his asset management business. He did not let everyone invest with him, so that those who were accepted felt privileged. His activities went on for so long without exposure that newer and older investors alike considered his investments to be legitimate, even if secretive. He bolstered his clients' confidence by quickly refunding investments to anyone who asked. Stock markets are not fully efficient, and a small number of investors, such as Warren Buffet, can consistently do better than the major indices over very long time periods. However, markets are sufficiently efficient that such a record is extremely difficult to maintain. It takes very many years to establish a good investment track record that is due to skill instead of a good record due to plain luck. The numerous investors not well versed in financial matters have great difficulty appreciating that there are no magical or secretive ways to consistently beat the market. This is why when anyone asks me for advice, I recommend buying a diversified portfolio of stocks and other assets that controls risk while providing decent returns. Some money managers may be able to beat that in the long run, but it is extremely difficult to discover who they are. As a result, most investors looking for exceptional returns are likely to be taken for a ride either by charlatans, or by lucky fund managers whose luck eventually runs out.

Comments

[SA]

A ``person who did not live especially lavishly''? A $7M apartment in NY, a $9M mansion in Palm Beach, a $3M beach house in Montauk, a 55 foot fishing boat, a yacht moored in the south of France, and half ownership of a $28M private plane?

[Anonymous]

see Battle for Investment Survival (book by Loeb) or something similar

I agree with diversification in general, with the addition of not letting diversification becoming substitute for spending some time and effort trying to understand each investment.

[Anonymous]

Dear Gary, if it turns out to be true, that on November 7th, 2005 the SEC has received a very detailed complaint about what is going on I think the SEC is liable for the scam. I do not expect investors to continue to have any faith in US capital markets and their regulators if us government turns away investors with their claims by saying it is your fold. Not acting on such a detailed complaint is a crime.

[Alex]

Professor,
An innate proclivity to commit the "denial of the antecedent" fallacy on a regular basis pragmatically requires education to tame.

The media, an instrument of education for the masses, unfortunately isn't interested in spreading the wisdom of efficient market theory. "Mad Money" and trading tool infomercials spouting technical analysis nonsense are the ruling religion of the day.

Keep the good faith. Fight the good fight. Your blog is a step in the right direction.

[AllenWZ]

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[James N. Markels]

I think a lot of investors are willing to outsource their investment decisions and not ask questions so long as the returns are good. And even when the returns are good, investors will push their managers if they discover that their neighbor is somehow doing even better. The good news is that the current economic situation and the Madoff revelations will compel people to act more responsibly. Investors must always be active and involved in their own investments. And investors need to make sure that their own greed does not overpower their need for security.

As for Madoff, what interests me is not that he ran a Ponzi scheme, but rather how he ended up running a Ponzi scheme. Coming from his background, I have a hard time believing that he decided from the start to create a massive Ponzi scheme that he knew would eventually blow up and ruin his good name. I think he started off doing a typical hedge fund. When times weren't so good, he sold some of the invested assets to fund overinflated returns to his investors, expecting that to attract new investors whose money he could use to reconstitute the sold assets. In other words, he may have been borrowing a page from Keynes -- when times are tough, sell assets and pay out good returns; when times are good, pay out lower returns and use the remainder to repurchase the assets.

Looks good on paper, except we all know that it just doesn't work. Selling assets when times are bad and buying assets when times are good is generally a losing "sell low, buy high" strategy to begin with. And investors don't stop demanding high returns just because the market improves.

Of course, it may be that Madoff intended to start a Ponzi scheme from the start, thinking that he had found a way to create one that would not crash and burn like all those before it. But he just doesn't seem to fit that profile to me. We shall see.

[Richard]

This will undoubtedly prompt a new outcry for heavier regulation of Wall Street. Maybe some of that is necessary. But as I see it, what’s mainly needed is a heavy dose of caveat emptor. As Dr. Becker points out, the warning signs were there. I think that there’s a limit on how far government can go in preventing people from doing stupid things (or making stupid omissions).

Media reports indicate that the auditing of the fund was inadequate. Adequate auditing seems to me to be the best way to ensure that funds are going to investments, rather than to a Ponzi scheme. I’m not sure what regulations are in place to see to it that an auditor is up to the job on the scale required, but perhaps they need to be augmented (or put in place, if they don’t already exist).

[Terry Johnson]

The knee-jerk reaction to this scandal along with all the others will be to add layer upon layer of new regulation.

While the new regulation may do an adequate job of correcting prior problems there will always be guys just a little smarter (maybe) and a little more dishonest (always) than the next guy.

The fact that wealthy individuals lost money is not a shock. Making money and keeping money are two different skills.

[Georg Kober]

The most obvious or at least the most interesting question to me is that:
Did Madoff really think he would get away with that? I mean, he must have known that one day, sooner or later, or even very later, people would find out and send him to jail. If I devised a Ponzi scheme, I would try to get as much money as possible in a short period and then travel to a sunny country without extraditon to the US or elsewhere. But living in New York for years, knowing that every minute someone could find out, that you would go to jail for the rest of your life and lose all what you have?
I admit, that is psychology, not economics; but for me this remains the real enigma.

[PRC]

The market IS NOT efficient. Example: well published results (see, most recently, Andrew Lo's book 'Hedge Funds') show the very simple technical strategy of longing each day's biggest positive movers and shorting the biggest decliners would have delivered SPECTACULAR returns in the 80's and 90's accounting for transaction costs and risk. And that the opportunity declined to zero in the late 90's and 00's. This is one of many technical strategies with similar return behavior in recent decades. There was an inefficiency in the market, and investors gradually discovered it and exploited it away. But over decades, not the much shorter timescales needed to justify idiotic and poorly informed 'the market is efficient!' statements that regularly spout from academic mouths. Is any of this ever acknowledged? What about strong return performance of funds like Renaissance and Goldman's Global Alpha (which, even including recent terrible performance, still destroys the market even on a risk-adjusted basis)? The market is in a state of some inefficiency, enough so that a number of investors (not just Buffet) can regularly beat it, but not enough that the average investor can. Agreed that it takes years of investment performance (and details beyond just yearly return) to tell the difference between luck and skill in investment success - this central fact is the reason swindlers can succeed, and that is what should be emphasized to investors if one wants to capture the real truth of the situation. Saying 'the market is efficient!' as well just spreads poor understanding and suggests those who work at generating returns in the market are all swindlers. They're not.

[Tom K]

I agree with James Markels above. Although it's just a hunch, I'm guessing that Madoff probably ran an ordinary business for quite some time, and then only needed to start scheming when things went bad. I wouldn't be surprised if he told himself that when he turned things around, he'd make up the money he lost. Typical gambler mentality - need more money to win back what you lost already.

[DaveinHackensack]

Diversification wouldn't have protected an investor from grievous declines this year. The only strategy that would have done that (other than staying in cash) is hedging. John Hussman, Ph.D., of Hussman funds hedged his Strategic Growth Fund, and so shielded his investors from the worst of the market declines.

[david]

Under your theory that anybody who consistently beats the market must be a scam artist, how do you know that Warren Buffet or any other money manager with consistent good results is not scamming?

Madoff was in business for almost 50 years and for most of it he was managing other people's money and providing good but not spectacular returns. For a great many investors, those facts alone would have provided a great deal of comfort.The huge amount of 20-20 hindsight being exhibited now by many is totally unconvincing.

It is also not clear what exactly would have been discovered by an SEC investigation. He clearly had money under management. The question is whether he had sufficient funds to cover all the amounts reported in the statements he issued to his investors. If he had enough funds to cover the amounts he reported he was managing, how would the SEC or nay other investigator have discovered that he was telling his investors (collectively) that he was managing a much larger amount than the amount he was reporting?

[neilehat]

"Ponzi Schemes", in the heart of the legitimate financial world? Looks like someone has taken a page from the "American Gospel of Success" - "There's a sucker born every minute" and why do you think it's called "SPECULATION".

The problem is clearly a lack of transparency that the SEC was supposed to provide.

And now the Financial Investment Banks that have taken money from the Nationally sponsored Bailout do not wish to report how that money is being used.

When are we going to learn and force these guys to toe the line and operate in the National Interest?

[Jack]

Aaah yes......... "transparency". And to think I used to read CPA generated 10Q and K's.......... what are those worth today????????? In an "efficient market?"

[Anonymous]

innocent until proven guilty

some people benefit from concentrated positions and specialization

not exactly frugal lifestyle

[neilehat]

Anon., Guilt and Innocence has nothing to do with it. A few need to be tarred and feathered and run out of town on a rail as a warning to others. Justice works in strange ways at times.

[immuddinuic]

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[Anonymous]

This is not the largest Ponzi scheme. That title would have to go to Social Security.

[Tom]

There are two posts above that deserve some translation......

On a separate note, for smaller than Madoff investors I recommend Bernstein's book, "The Intelligent Asset Allocator". Pretty much agrees with Prof Becker.

Brokers are not your friend.......

[fleefevam]

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[Jack]

Not to excuse Madoff but it is interesting to consider what constitutes a Ponzi scheme; is it intent?

Consider Amazon operated at a loss for years, ostensibly plowing all of its revenue into buying market share and striving to preempt competition while its stock rose on expectations of profits certain to come as its founder indicated would be the case. But suppose his model was flawed and Amazon went down as did so many other dot coms?

Then with the dot com frenzy in full swing, WERE there hucksters who had no intent of ever being profitable and intentionally just sold a story, churned some dollars for a while (as was, apparently, part of AOL's "business plan" for a while) go public and "diversify" the capital raised.

Or, more topically, did very savvy investment bankers REALLY think that they HAD invented something that made the "old" 5 : 1 lending ratio obsolete and that going out to 30 : 1 was a viable business practice?

Or? By offering returns far above the historical norm to their investors for selling what MANY insiders MUST have KNOWN was junk also guilty of running illegal Ponzi schemes? Or where they just frisky young capitalists willing to take just a bit more risk in order to maximize returns for their stockholders? Did they think they could reduce their exposure to risk, IF, or before asset prices flattened or fell?

By comparison, did Madoff, think, or hope that after "buying customers" with high returns and getting his fund to some size that he could catch up by lowering returns while maintaining most of his client base? Probably not, and I assume there are some rules against running funds in a manner that returns more than was earned in a given year.

But what of those lending at 30 : 1? That would make 5% loans yield something like 150% on equity. Would a CPA using generally accepted principles endorse such returns as "earnings?" or denounce them as lucky winnings from wild-azzed gambling? or outright fraud?

[Woophynip]

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[HoossyborePox]

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[pntmhjzkv ucmgfzj]

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