Professionalism/Bernie Madoff's Ponzi Scheme

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When Bernie Madoff's asset management business was uncovered as a Ponzi scheme in December 2008, his clients lost more than $50 billion dollars in deposits overnight. Madoff's operation is widely believed to be the largest Ponzi scheme ever attempted.

In the reporting and analysis that inevitably follow these sorts of headline events, there is a tendency to focus on the unique badness of the perpetrator. Men like Madoff often end up portrayed in a movie super-villain archetype: individuals of exceptional ability and intelligence, who are restrained by no moral code of conduct.

However, this view of events brings us up short. If our understanding of these types of events teaches only that "Smart bad people can hurt you", then we have gained nothing of practical value. If we wish to take away generalization lessons from cases like Madoff's, we must be willing to examine events with a broader lens, and scrutinize not just those who acted maliciously, but also those who failed to act.

Bernie Madoff[edit]

Bernie Madoff was the founder and executive chairman of Bernard L. Madoff Investment Securities. Madoff Investment Securities was primarily a “market maker” - a company that profits by facilitating trades on various securities. At the time the scandal broke, they were the sixth-largest market maker. They were quite innovative, and pioneered the use of computer systems in market making, creating technology which eventually spawned the NASDAQ.

They also had a secondary side business of financial advising and asset management. This part of the company was eventually exposed as a massive fraud.

Ponzi scheme[edit]

Madoff's asset management business claimed that it invested client assets using a highly secretive trading strategy. In reality, it was actually operating as a Ponzi scheme - no money was being invested, and all investor payouts came from the deposits of new and existing investors.

Ponzi schemes typically draw in investors by offering rates of return high above the market average. Madoff's fund was more subtle - rather than offering sky-high returns, it simply delivered strong consistent returns in all market conditions.

Throughout the 80's and 90's, the unerring consistency of the Madoff fund gained a reputation among the investment community. Charities and wealthy individuals enthusiastically entrusted their money to Madoff, who by now had a reputation as a "financial wizard".

The scheme's unraveling[edit]

On December 9, 2008, Madoff confessed to his adult sons that the entire asset management business was a Ponzi scheme, and that it was out of money.

At the time, the fund had obligations of more than $68 billion to it's investors. However, it had less than $200 million in available cash to satisfy withdrawals.

Based on advice from their lawyer, the sons turned their father in to the FBI. Bernie Madoff was arrested on December 11, 2008, and is now serving a sentence of 150 years in federal prison.

Investors at the time of Madoff's arrest had almost all of their assets wiped out. This affected the Jewish community in New York particularly strongly, as Madoff had provided investment services for many Jewish organizations and wealthy individuals in the city.

The SEC[edit]

The U.S. Securities and Exchange Commission (SEC) has three goals: to facilitate capital formation, maintain a fair & efficient market, and protect investors. [1] The collapse of Madoff’s Ponzi scheme was one of the largest and most notable failures in the SEC’s history, leading to sweeping changes within the organization on how it identified and dealt with investment management fraud. [2]

Harry Markopolos[edit]

Investigations into Madoff’s investment strategy started as early as 1999 when Harry Markopolos, a portfolio manager at an investment firm, was tasked with replicating the strong returns that Madoff claimed to attain using a split-strike conversion strategy. Within a few hours, Markopolos had determined that Madoff could not have produced his returns through strictly legal means. Markopolos continued building his case against Madoff until he had compiled a formal complaint that he submitted to the Boston office of the SEC in the spring of 2000. This report was met with inaction from the SEC, and so Markopolos submitted an even more extensive complaint in 2001. This report, too, was ignored. [3]

The world's largest hedge fund is a fraud.

— Harry Markopolos

During his investigation into Madoff Investment Securities, LLC, Markopolos found that the fund was accepting foreign money, which he interpreted as being connected to criminal organizations outside of the United States. Although he began to fear that his life may be in danger by continuing to try to expose the fraud, [4] Markopolos produced one final report in 2005 in which he identified 29 distinct red flags that should raise suspicion about Madoff’s fund. The report, titled “The World’s Largest Hedge Fund is a Fraud,” included a preface about the sensitivity of the information as well as a summary of the impact the scheme would have on the financial industry if it did in fact turn out to be fraudulent. [5]

Failure to Regulate[edit]

Two main factors contributed to the SEC’s failure to act on the available information. First, the organization’s structuring meant that the Boston office that Markopolos originally alerted of discrepancies in Madoff’s investment figures had no authority to act in New York. The Boston office could only encourage the New York office to launch an investigation, which was hindered by poor relations between the two offices. In addition, many of the employees at the SEC were lawyers, untrained in understanding the numbers behind the financial organizations they were monitoring, and were therefore unprepared to identify fraud when it did occur. [6]

Second, a whistleblower from within the SEC claimed that there was an unofficial policy at the New York SEC office to avoid taking cases dealing with investment management fraud. The whistleblower noticed that such cases rarely proceeded to formal investigations, so she confronted a supervisor about the issue, only to receive the reply: “We don’t do investment management cases in this group.” [7] Limited resources available to the SEC combined with the large number of investment managers may have contributed to this policy, although the persistence shown by Markopolos and the ease of exposing a Ponzi scheme should have encouraged the watchdog agency to make exceptions where sufficient evidence existed. [8]

Even in the face of numerous warnings from outside sources, the SEC failed to take the appropriate action in regulating a segment of the public sphere that it alone had the authority to regulate. This negligence facilitated Madoff’s fraud, which would not have been possible if the SEC had taken the standard of care that would be expected when dealing with such a large investment fund.

Investors[edit]

From the moment the Madoff scandal broke, the many groups that invested in his fund were labeled as "victims." The reality of the situation was not so simple, however. The people that invested in Madoff's fund were not run-of-the mill or uneducated investors. Most of Madoff's clients were banks, hedge funds, very wealthy individuals, or charitable foundations. These were all groups who were sophisticated enough that they should have been incredibly suspicious of Madoff's returns.

Madoff's investors exhibited two sets of behavior that were strange of well-informed and educated investors. First, they refused to investigate the suspiciously good returns that they received. Second, many of the investors did not diversify into anything but Madoff's fund, violating one of the central tenants of investment.

Willful Deception[edit]

With results as good as Madoff's [9] few investors wanted to look for a reason to distrust him. Madoff used that bias to powerful ends, creating a web of illusion that fed the biases. First, he created an air of exclusivity around himself that offered an unspoken explanation of his success: that it was only for the few that were in the know. Madoff rarely approached potential investors directly, choosing instead to let suitors come to him. Second, he fed off of the bystander effect. Potential investors saw that other individuals and institutions trusted him, so they saw no need to question anything. In their mind, the largest hedge fund in the world was either a complete fraud that would decimate the financial system, or they were the only ones not reaping the rewards of Madoff's fund. It was much easier for them to believe the latter.

Moral Hazard[edit]

Another reason why Madoff's scam lasted for so long was that he was unknowingly aided by a network of feeder funds that guided money into Madoff's hands. The list of investors were not random, but highly related [10]. This created a network effect around Madoff. People with direct access to his fund would charge fees for allowing those farther out in the network the privilege to invest. Many banks gained a significant amount of income by simply directing people to Madoff. They had a strong incentive, a classic example of Moral Hazard, to ignore suspicious returns.

A Rare Warning[edit]

There were a few banks that did take a closer look at Bernie Madoff's suspicous results, however. Credit Suisse was one of those banks. A group led by Oswald Gruebel, the head of private banking, met with Madoff in 2000. Gruebel asked a series of pertinent questions: Why did the firm have an obscure auditor? Why wasn't a third-party holding his clients' assets? Why wouldn't he reveal how much money he was running?

If you are not happy with the returns you are getting, you can take your money.

— Bernie Madoff to Oswald Grubel

After only a few questions, Madoff ended the meeting, saying, "You guys, if you are not happy with the returns you are getting, you can take your money" [11]. Gruebel recommended that all Credit Suisse clients withdraw their money from Madoff funds. Only about half of the money was taken out. Those that remained lost everything.

Perceptive Greed[edit]

There is a darker side to Madoff's clients than just ignorance or greed, however. Many of his clients invested in his fund not in spite of his suspicious returns, but precisely because the returns seemed so phony. These clients believed that Madoff was "front-running" money. In other words, they thought he was using information illegally gleaned from the legitimate part of his business to conduct a form of insider trading. Madoff himself has claimed that banks knew he was committing fraud, but chose to do nothing about it [12]. In 2008, just days after the scam was exposed, Swiss bank Union Bancaire Privee gave their reasons for investing with Madoff: "in essence, the percieved edge was Madoff's ability to gather and process market-order-flow information to time the implementation of the split-strike option strategy" [13]. Although disguised in financial lingo, the bank was essentially admitting that they assumed Madoff was front running.

They were convinced that the risk was only that the Securities and Exchange Commission would do something...what could be expected was that at a certain point the SEC could say stop

— Werner Wolfer on banks' acceptance of potential fraud

Swiss banker Werner Wolfer put it more succinctly: "They were convinced that the risk was only that the Securities and Exchange Commission would do something about breaches of the Chinese wall in the Madoff organization. [In the worst case] what could be expected was that at a certain point the SEC could say stop."

Ultimately, many of Madoff's investors correctly saw that his results could not have been legitimate. They were simply incorrect on the method of fraud. By turning a blind eye to the fraud they expected, front-running, they instead were caught unaware by the fraud they did not expect: a massive ponzi scheme. While portrayed as victims, many of Madoff's clients were also responsible for the scheme, either through knowing or unknowing participation. In the end, they were convicted by their own greed.

References[edit]

  1. [1], The Role of the SEC
  2. [2], The Securities and Exchange Commission Post-Madoff Reforms
  3. [3], Testimony of Harry Markopolos Before the U.S. House of Representatives
  4. [4], Madoff whistleblower speaks at Framingham State
  5. [5], The World's Largest Hedge Fund is a Fraud
  6. [6], Madoff Whistleblower: SEC Failed To Do The Math
  7. [7], SEC whistle-blower says she was frozen out by new enforcement chief
  8. [8], SEC Didn't Act on Madoff Tips
  9. [9], The Madoff Case: Quantitative Beats Qualitative! Two Red Flags: Bias Ratio and Risk Profile Clearly Pointed to Problems With Madoff
  10. Wall Street Journal, Bernie Madoff's Client List
  11. Bloomberg, Madoff Enablers Winked at Suspected Front-Running
  12. The Guardian, Timeline: Key dates in the Bernard Madoff case
  13. Bloomberg, Madoff Enablers Winked at Suspected Front-Running