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.