How to run a Ponzi scheme

Investors may have been duped because Mr. Madoff sent detailed
brokerage statements to investors whose money he managed, sometimes
reporting hundreds of individual stock trades per month. Investors who
asked for their money back could have it returned within days. And
while typical Ponzi schemes promise very high returns, Mr. Madoff’s
promised returns were relatively realistic – about 10 percent a year –
though they were unrealistically steady.

It seems this scheme went on for "years or even decades," which means it lasted longer than many legitimate concerns.  Nomura had been searching out international clients for him.  Checks and balances were weak:

…because he had his own securities firm, Mr. Madoff kept custody
over his clients’ accounts and processed all their stock trades
himself. His only check appears to have been Friehling & Horowitz,
a tiny auditing firm based in New City, N.Y. Wealthy individuals and
other money managers entrusted billions of dollars to funds that in
turn invested in his firm, based on his reputation and reported
returns.

In reality the "fund" simply was not there and now grandmothers have been fleeced.  That is a scary lesson about the financial sector as a whole (and prudential regulation) but if it is any comfort an unregulated hedge fund could not have done the same.  Those funds hold their portfolios at banks and thus you can check as to whether they actually "exist."

Comments

My father was in a bar business 40 years ago with a guy who did loan sharking for the mob -- not the muscle just the loaning. This guy got the brainstorm to make up loans and just pay the points (two percent a week) out of the principle he kept borrowing for the imaginary clients. It worked swimmingly for quite a while, well over a year, until someone got wise and he got dead quick. The mob, of course, took the bar and the license as further punishment. Madoff is getting off relatively light. Extremely light.

Not sure what you're claiming about "prudential regulation", but Madoff was registered with the SEC, which had prior warnings about him and did nothing. His SEC registration no doubt gave him an imprimatur which led investors to trust him.

What I find suprising in the NYT article is the description of how many
hedge funds had assets invested in this "fund" - some had substantially
all assets invested in this "fund." And also the description of banks and
"hedge fund advisory firms" that directed client's money to hedge funds.
My guess is all the hedge fund and hedge fund advisory firms managers were
very well paid.

Was anyone actually investing any money on Wall Street/Greenwich, or were
they just passing the moeny back and forth and booking big fees?

Jason, a lot of grandmothers *are* the idle rich.

Note well that several hedge funds were investing in Madoff's Ponzi scheme:

"And at least three funds of hedge funds -- which raise money from investors and farm it out to hedge funds -- may have significant losses. Fairfield Greenwich Group and Tremont Capital Management of New York placed hundreds of millions of their investors' dollars into funds overseen by Mr. Madoff. On Friday, Maxam Capital Management LLC reported a combined loss of $280 million on funds they had invested with Mr. Madoff."

I used to represent an investment/securities firm. I withdrew for ethical reasons. I was skeptical of the markets before, but now I'm completely satisfied that anyone who buys into them is either #1 an idiot or #2 acting on insider information (or what they think is insider information, and it's not, and thus see #1) and is thus a criminal.

You're better off putting your money on the craps table, roulette table, or just taking it safe and playing blackjack. And you won't have to pay anyone a commission to tell you whether to bet your chips on red or black.

Come to think of it, I'm actually surprised there are not "professional wager advisors" in Vegas who either bet your money for you, for a chunk of the winnings, or tell you how to bet for a commission of each bet (e.g. each 'trade').

When an individual does this it is called a crime -and it is. When the government does it it, is called Social Security.

Don't miss this article at Clusterstock: "I Knew Bernie Madoff Was Cheating--That's Why I Invested With Him".

The gist of it, a number of sophisticated investors did due diligence and figured out that Madoff was not legit. However, they guessed wrongly that what he was doing was either illegal front-running in his market-making business, or perhaps some kind of insider trading. And then they invested with him anyway, because they wanted their very own laundered piece of those ill-gotten profits. The joke was on them. If you can't figure out who the sucker is, maybe it's you; even if you think you've figured it out, maybe it's still you.

Blagojevich... Dreier... Madoff. It hasn't been a good week has it? The rot is very deep at the highest levels. This will matter a great deal when things seriously start to fall apart in the coming year or two.

If only Madoff had had the foresight to include a clause in his client agreement allowing him to freeze redemptions (like many hedge funds are now doing), maybe he could have kept the scam going for many more years.

"When an individual does this it is called a crime -and it is. When the government does it it, is called Social Security."

Congrats on your "Most Retarded Comment of the Day" award.

Tyler this doesn't appear to be sound logic to me:

TC: "grandmothers have been fleeced"

Commenter Jason: "and now grandmothers have been fleeced"???

More like the idle rich.

TC: Jason, a lot of grandmothers *are* the idle rich.

The class that has been fleeced appears to be "the idle rich". Jason has it correct. This may include some grandmothers, but this doesn't mean grandmothers were the class that was fleeced.

Reminds of Keyensian logic.

"Congrats on your "Most Retarded Comment of the Day" award."

Why? If Social Security is called an "investment" which you "contribute" to, then it's a Ponzi scheme. Of course, it really is a wealth redistribution from the young to the old, and the old therefore rely on enough production from the young to survive.

When we end the myth of Social Security as an investment and realize that it is a welfare program, reform going forward will be much easier.

So, maybe there are good reasons for the current liquidity crisis?

As J.K. Galbraith said, recessions uncover what auditors miss.

That is a scary lesson about the financial sector as a whole (and prudential regulation) but if it is any comfort an unregulated hedge fund could not have done the same. Those funds hold their portfolios at banks and thus you can check as to whether they actually "exist."

Rather than getting sidetracked into which is the flippest descriptor for the victims of Madoff's scheme, I'd rather hear support for this comment. Technically, the money in a Ponzi scheme "exists" until the organizer fails to rope in the new investors he needs to pay off the earlier investors. It is only less than one would expect if one knows the total sum invested (the disclosure of which requires regulation). Seemingly Madoff was able to rope in new investors for years, so whether he had the money tucked away under his matress or deposited in a bank is fundamentally irrelevant. Neither works as an early warning against a Ponzi scheme.

An unidentified commenter wrote:
"When an individual does this it is called a crime -and it is. When the government does it it, is called Social Security."

Meter replied:
Congrats on your "Most Retarded Comment of the Day" award.

I have news for you, Meter. SS is a Ponzi swindle.
If everyone who has contributed money to it demanded to be taken out and given his money back, with a market rate of interest paid on those contributions, it would collapse like a house of cards.
If an insurance company were run like SS, the execs would go to jail.
Unlike a private insurance plan, which relies on contractually-based payments and at least tries to obtain a market return on its assets, SS relies on workers being forced to pay a continual stream of money to fund retirement and disability claims for other people. It also gets submarket returns on its capital by design.
A lot of people, myself included, would never have contributed a dime to SS had we been given a choice.
Without force SS would never have existed.

Notice that since the early to mid-80's the Dow Jones Industrial Average, Nasdaq, and the S&P 500 may suggest serial correlation. Someone should do some mathematical analysis on this. I'd be interested to hear comments on this. As Ritholtz suggests, we're looking for a nice smooth line, with consistent almost unbelievable gains. From the 80s on, if you throw out the bubbles in each of these graphs, it looks very much like a nice pretty line extending to the sky. Year on year growth, as any financial adviser at any mutual fund or retirement investing firm will say, can be expected to be in the 10% range over the long haul - because the stock market always goes up.

An interesting note: the invention of the 401(k) in 1978 and almost half of U.S. corporations offering them by around 1983 correlates to the beginning of the last roughly 30 years of increases in the DJI. The universalization of 401(k)'s is today easily apparent.

Are all the U.S. workers contributing to 401(k)s and IRAs just a part of one big Ponzi Scheme?

"When an individual does this it is called a crime -and it is. When the government does it it, is called Social Security."

Congrats on your "Most Retarded Comment of the Day" award.

It is not the most retarded comment, it is the most accurate comment. Social Security is a big ponzi scheme that is going to crash (or is crashing) when the boomers start retiring in mass. Plus, it is not diversified and it is invested in non-inflation hedged treasuries - all the eggs in one basket and no outside auditors and no outside custodians - just the Government watching over it for us. Once again, it is not the most retarded comment, it is incredibly accurate to compare social security to a ponzi (or should we call it Madoff) scheme.

As a financial fraud investigator, I applaud the few professionals who saw through a modest high-yield fraud scheme. Very few people understand the methods used to expose these types of frauds, and fewer yet if we include the fraudsters. Those who parted with their money, like Madoff, believed in the tooth fairy.

Lesson: If it's a significant amount of money (i.e. money you can't afford to lose), consult several professionals. Believe the least optimistic. Madoff's books and returns would have been exposed by such simple analysis as the application of Benford's Law.

meter and ogmb,

Madoff wasn't a traditional hedge fund, charging 2% and 20% of profits, using a prime broker to execute its trades and borrow money from for leverage, using a large and recognized auditor firm. Rather, it was a broker/dealer with an asset management division, claiming to charge no fees and make its money on commissions only, relying only on itself for what turned out to be fictitious trades, and using a no-name three-person accounting firm. (see Information Arbitrage for instance)

A traditional hedge fund could blow up from poor trading strategy or conceivably from fraud, but it could not sustain that fraud over more than a decade like Madoff did because there are too many third-party eyes that could look into its dealings.

Derek Scruggs wrote:

I'm not a fan of Social Security, but I've never heard it described as an investment. It's an insurance policy, and that's how FDR sold it. The official name of Social Security is the Old-Age, Survivors, and Disability Insurance (OASDI) program.

If anyone is responsible for the so-called myth, it's the political right, who wanted to privatize it so people could get better "returns" on their "investment."

SS is a tax (on workers)-and-spend (on retirees or disabled ex-workers or more likely scam artists) Ponzi scheme. It's not an insurance policy, despite misinformation to the contrary. Insurance is based on a voluntary contractural arrangement, and is actuarially sound, neither of which are true of SS.
If an insurance company were run like SS, the executives would be guilty of fraud and put in jail, the way Bernie Madoff undoubtedly will be.

SS should be privatized. People should also be allowed to opt out of it. As Wally Mondale pointed out in 1980, that would cause it to collapse like the Ponzi scheme it is.
Just another New Deal fraud.

"That is a scary lesson about the financial sector as a whole (and prudential regulation) but if it is any comfort an unregulated hedge fund could not have done the same. Those funds hold their portfolios at banks and thus you can check as to whether they actually "exist." --- Tyler Cowen

1) This seems strange, Tyler: wasn't Madoff running a hedge-fund himself, and not a private-equity firm (the difference fairly fuzzy anyway, largely depending on what each of them invests in: liquid or illiquid funds).

2) You'd think the 1998 fiasco of Long-Term Capital Management, run by two Nobel prize-winning economists, would have signaled clearly that hedge-funds should be strictly regulated like mutual funds . . . a decision reached by Henry Paulson and others a decade later amid a systemic financial meltdown on a global scale. (Yes, I realize: the meltdown and crisis in financial markets wasn't mainly the responsibility of hedge-funds, but of more "regular" firms like Lehmann, Bear Stearns, AIG, and credit-swap scammers galore, creating a global chain of fantasized solid risk-analysis as well as cunning con-artists).

Back in 1998, recall, LTCM was leveraged 30 times its $4 billion in investor-funds, not to mention a $1 trillion of off-balance notional stuff. And it needed a Federal Reserve rescue. Now the entire financial system needs rescue, along with the US and global economies . . . though it will only be a matter of time before real business-cycle theorists will produce multi-regression analyses showing the current nosediving recession world-wide is really only a matter of a temporary deviation from long-term trend growth caused by a predictable dip in the marginal productivity of capital and technological negative-shocks that will soon be rightened.

.......

3) Never mind. Very wealthy geniuses apparently flourish with the approval of free-market zealots in financial markets, regulated or unregulated . . . with all but minimal risks incorporated into efficient market prices. And as Alan Greenspan argued back in 1995-96, who are governmental regulators to think that they can outwit these geniuses and other clever innovators . . . especially since they can be counted on to look after the interests of their investors.

(Alan is still, presumably, in a state of shocked disbelief this fiduciary responsibility didn't materialize, and is probably consulting several articles at the Ayn Rand Institute to see how "objectivism" went wrong. And Larry Summers and his crew in the late 1990s did their share too, come to that, to slap down the few financial regulators at the SEC and elsewhere worried about the boom in new financial derivatives and other complex financial innovations.)

.....

4) You'd think anyway that the US had drifted into a weird economy when, last year, the top 20 or so hedge-fund managers earned more than the nicely paid CEO's of the Fortune 500 . . . a nice windfall that, presumably, made the hearts of most of the posters in this thread gladden with the news, yes?

....

5) So where are we?

Well, for an outstanding analysis of Hedge Funds --- why they seemed despite everything to flourish and why they will now be strictly regulated (and in such an environment a few will flourish) --- see this remarkable article by Jesse Eisenger at Portfolio.com.

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Michael Gordon, AKA, the buggy professor

It doesn't look like an insurance policy.

It's an inflation-protected annuity. It's insurance against outliving your income.

Everybody can't save enough for that eventuality, but everybody can afford to pay for the annuity (since most don't live that unexpectedly long). It's perfect for an insurance model.

Furthermore only the government can be relied on for inflation protection; a private company isn't going to be there in thirty years when you need it.

Those funds hold their portfolios at banks and thus you can check as to whether they actually "exist."

YOU can't. The bank or the clearing house could check, if it was the only one used by the hedge fund.

In reality hedge funds have accounts at several banks so that no single bank can illegaly see their whole strategy and front run them. So noone is seeing the whole picture and verify whether the the fund has those stated 50 bln or only 10.

To Bill Stepp...you said insurance companies are "actuarially sound"...and "
If an insurance company were run like SS, the executives would be guilty of fraud and put in jail..." So that's why a lot of insurace companies nowadays caught up in the credit crunch are in the rush to buy banks so they they can get TARP money. And AIG, the world's largest insurer, would be "actuarially sound"?

And by the way, despite predictions by economists (which Phillip Tetlock shows turns out be a bunch of baloney) SS still works. 2008 Nobel Prize winner Paul Krugman believes it will work with minimal infusions of tax increases. So please try to keep your comments a little more on the impartial side.

http://biz.yahoo.com/ap/081215/wall_street_arrest.html

Doesn't that picture of Madoff look almost identical to Charlie Sheen's first workspace in 'Wall Street'?

close italics?

third time lucky? test
fourth time lucky? test

Who cares it just a lot of rich jews that got fleeced. good for those greedy people

I should add: you sound like the kind of guy who is anti-pension too.

So, what's your sage advice for handling retirement other than to "be rich?"

They will have to pay it off over many years.

National bankruptcy would be a problem if the debt was greater than total Icelandic wealth. GDP is the flow of income and output generated by that wealth. Presumably, the wealth is a multiple GDP.

I was in debt by more than my income. I would have said that my income grew by less than the interest rate too. I wasn't insolvent because my home was worth more than my debt. And, of course, my consumption was less than my income allowing me to actually pay off my debt a little over the years.

Presumably, this new loan to Iceland is supposed to be used to pay off other loans. And perhaps other loans that aren't being paid off add up to many times GDP. Perhaps Icelandic national insolvency is inevitable. But a loan equal to GDP and interest rate equal to GDP growth doesn't imply this at all.

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