The most surprising aspect of the Bernard Madoff scandal is that it makes Illinois Gov. Rod Blagojevich look lame. Wall Street flim-flim man Madoff scammed the nation’s wealthiest out of enough money to buy all three American car giants; Blago just wanted a cushy new job. Child's play!
The evidence is still mounting, but the Securities and Exchange Commission (SEC) has estimated that Madoff’s con job may cost his victims over $50 billion. Blagojevich just limited himself to thinking he could get a million dollars.
Though some may try to bill the multi-billion dollar swindle as new evidence in the case against evil capitalism, this has little to do with exotic investment vehicles or over leveraged hedge funds. Madoff's con is just your every day, run of the mill Ponzi scheme—it just happens to have been run by the Frank Sinatra of Wall Street.
What exactly is a Ponzi scheme? In 1920, former banker Charles Ponzi started a scam that offered investors a 50 percent return on their money within 45 days. Within just a few months he was pulling in $250,000 a day, paying off the first investors with money from later investors, planning to run with the money once he had what he wanted. The scheme fell apart before the year was over and Ponzi got five years in prison.
Last week, as the Madoff facade was torn down, he met with his few employees and admitted, “It’s all one big lie...basically a giant Ponzi scheme.” It appears his investors, all extremely wealthy people and organizations that understood investment risk, will suffer significant loss.
However, the Madoff scandal is not unconnected to the ongoing financial crisis. In fact, it is intimately related—though in a surprising way.
John Kenneth Galbraith wrote in The Great Crash of 1929 that economic crises have a profound effect on embezzlers. “At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country’s businesses and banks.” When the economy is doing well, people are relaxed and trusting. This environment can lead to decreased vigilance on the part of investors and regulators alike, allowing such larcenous activity to grow. But when recessions strike, the jig is up.
Though Galbraith was writing of embezzlement scandals revealed by the Great Depression, this is essentially what happened to Madoff. When the market turned down it caused a run on his funds, revealing the bank vault to be empty.
During the past several strong years for the market, the Wall Street giant was able to redirect funds invested in a special division of his company, BMIS, LLC, to increase its net worth without anyone noticing—or at least without getting caught. As long as the market was bullish Madoff's Ponzi scheme held up. He took his investor’s money and said he was going to invest in stock options, hedged to guarantee a safe return. Though his investors were told the money was earning 8 to 12 percent a year, the money was never invested as he said.
Madoff ran the scheme out of his BMIS office, keeping the company in the dark about what he was doing, his secret books under lock and key. From there he generated false return statements and hid away the cash. But when stocks tanked in September, the con broke down. He didn’t have the money everyone thought he had and the fraud was exposed once investors fled the market, looking for safer harbors.
Recessions thus have the effect of clearing the market of inefficient and misguided allocation of resources. As the business cycle turns down, poorly managed businesses are exposed, unwise investments are revealed, and illegal activity, such as Madoff’s Ponzi scheme, falls apart.
Madoff didn’t have anywhere to run. He was a prominent figure in high society, a member of the nation’s most exclusive clubs. He was a former NASDAQ chairman who founded one of the most successful securities firms in Manhattan’s financial district. How could he disappear? Requests piled up for $7 billion to be pulled out of the market, but the confidence man didn’t have the money to payback the once-thought-to-be billionaires.
This highlights the essential importance of recessions in the market cycle. They clear away the junk that develops over time as people become over confident in the market and make poor investment choices. If the Treasury had been able to somehow stop the market downturn in September, this scheme never would have come out of the darkness.
There are other aspects to recessions, negative ones, to be sure. And those can't be ignored, but this benefit should be considered as well, especially as officials tend to see only the doom and gloom. Letting the market work out its own kinks is critical to future market strength.
There will certainly be a push for increased regulation in light of this scandal, but that’s the wrong policy approach. It’s not as if more laws would have caught Madoff's scam. Rather, this scandal highlights the ineffectiveness of regulatory agencies such as the SEC. This should temper the faith we put in them, not cause us to increase their power.