A $50 Billion Ponzi Scheme

More laws and further regulation wouldn't have prevented the Bernard Madoff scam

Anthony Randazzo | December 18, 2008

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.

Wall Street analysts and pundits are now saying, in review, there were a lot of red flags that should have brought down this scheme. The SEC was even warned, as early as 1999, that Madoff was running a Ponzi scheme. The SEC began two investigations, one in each 2005 and 2007, though neither amounted to much. Madoff’s prominence loomed larger then any accusation or inquiry (he even helped advised the government on how to stop fraud).

The answer is not to give the SEC more teeth, more red tape, and more rules to complicate operating in a “free” market. Rather, the market should simply be less dependent on intense regulation, and less trusting of the power of the federal government to effectively police its increasing number of rules.

The law exists to protect property rights, and thus in this case the government has a judicial role to play. The government should also establish rules of the game for the market to operate within. However, the investors also have a legitimate individual responsibility to understand how their money is being invested. Many simply put their trust in Madoff, and simply accepted the too-good-to-be-true rate of return. There is a degree of personal responsibility when it comes to finances, despite the deception of Madoff.

Anthony Randazzo is a policy analyst and the Koch associate at Reason Foundation. An archive of his work is here

Comments

Jeff P|12.18.08 @ 4:35PM|#

Somebody publish a story claiming the welfare fraud stands as evidence against welfare and see what happens.

Naga Sadow|12.18.08 @ 4:37PM|#

Good article. Though your final part about less regulation will not be heeded outside these circles. (sigh)

|12.18.08 @ 4:44PM|#

Madoff's con job may cost his victims over $50 billion

That's-a spicy meat-a-ball!

|12.18.08 @ 4:49PM|#

Obama didn't hesitate to add this episode to the crusade for more regulation. Yeah, the SEC screwed this one up, but crooks will game the system regulations or not. I include the bankers under the crook umbrella.

|12.18.08 @ 4:49PM|#

This guy my cousin and i were gassing with in the bar a few weeks ago wondered why I laughed in his face when he said he could "get us in on the ground floor" with a guy "guaranteeing" eleven percent in Florida real estate.

Jesus H Christ the eleven percent guaranteed was bad enough but, come on, Florida fucking real estate?

I guess none of the guys who invested with Madoff ever got the advice "if it sounds too good to be true, it probably isn't."

|12.18.08 @ 4:53PM|#

An interesting detail about Ponzi's scheme is that it involved buying international reply coupons in Italy, exchanging them for stamps in the US, and selling the stamps. Post-WWI inflation in Italy made this quite profitable in theory, but the plan didn't scale well.

Gilbert Martin|12.18.08 @ 5:33PM|#

The biggest Ponzi scheme in history is the one run by the United States government - the Social Security program.

When somebody in the private sector creates a Ponzi scheme, they go to jail when they get caught.

When politicians pass laws to create a government run scheme, they get lauded for their "compassion".

jtuf|12.18.08 @ 5:36PM|#

So in other words, Madoff ran his investment vehicle like the social security trust fund.

anarch|12.18.08 @ 5:49PM|#

So in other words, Madoff ran his investment vehicle like the social security trust fund.

miche|12.18.08 @ 5:53PM|#

This Madoff thing touched my home as I learned last night that mom-in-law had $150k with his outfit.

Lefiti|12.18.08 @ 6:29PM|#

You fucking loony market fundamentalists really are worried about somebody making the case against evil capitalism, aren't you? Kind of like religious fandamentalists panicking over evolution.

anarch|12.18.08 @ 6:51PM|#

An urban legend - whether true or not I don't know - has it that many years ago, as a prank, some students established a union membership for a fictitious auto-worker, and that the non-existent worker, long after he would have died a natural death, continues to amass benefits such as social-security and profit-sharing accounts.

I think that's happened with Lefiti here.

nebby|12.18.08 @ 7:05PM|#

Uh.. regulations were the answer here. The SEC just did not do their job in enforcement.

Kolohe|12.18.08 @ 7:20PM|#

The SEC just did not do their job in enforcement.

Concur, but the people that were paid 2 and 20 for their expertise but wound up just giving their money to Madoff no questions asked are even more the blame.

|12.18.08 @ 7:46PM|#

What nebby said ... regulations were in place that would have put the kibosh on this scheme, but nobody who could paid any attention to enforcement.

|12.18.08 @ 8:42PM|#

Uh.. regulations were the answer here. The SEC just did not do their job in enforcement.

And you don't see that as an inherent problem with relying on regulation?

Naga Sadow|12.18.08 @ 8:50PM|#

FOOLS!!! ALL FOOLS!!! I promise a 3000% return on assets! Just post your bank account #'s on Hit @ Run! Checks in the mail people!

|12.18.08 @ 8:52PM|#

If anyone has been through an audit of their investment portfolio by regulators of any kind, you know how simple it is. In general, they check the books (holdings and valuation) of the company vs what is in a 'safekeeping' account held by a third party.

it ain't rocket science, that's for damn sure. the 'regulators' and audit firm just plain suck. due-dilligence by investment managers and individuals sucked as well.

bill|12.18.08 @ 8:59PM|#

Here's an interesting addition to the Madoff scandal.

http://www.rense.com/general84/mado.htm

nebby|12.18.08 @ 9:00PM|#

"And you don't see that as an inherent problem with relying on regulation?"

Nope. Shitty execution does not necessarily indict the playcalling. I have my problems with LEO, but I still believe in law.

Lefiti|12.18.08 @ 9:19PM|#

Gilbert Martin should win the Market Fundamentalist of the Year award.

Lefiti|12.18.08 @ 9:23PM|#

"The United States effectively has a one-party system, the business party, with two factions, Republicans and Democrats. There are differences between them. In his study Unequal Democracy: The Political Economy of the New Gilded Age, Larry Bartels shows that during the past six decades 'real incomes of middle-class families have grown twice as fast under Democrats as they have under Republicans, while the real incomes of working-poor families have grown six times as fast under Democrats as they have under Republican.'" --Noam Chomsky

|12.18.08 @ 9:56PM|#

We all need to stop calling people who put money in the stock market as "investors". They are gamblers. Lets be clear, the stock market is no longer a means for companies to generate working capital it's become an avenue for gamblers to try their luck. Unfortunately they have built a financial sector which strives to legitimize the corruption. It's too bad our greed has exceeded our common sence and allowed us all to fall victim to the perils of the stock market and reduce our pension funds to a shadow of their worth.

Famous Mortimer|12.18.08 @ 11:23PM|#

Jesus, here we go again.

We get an honest critique of market exploiters, and in a panic the econ-fundamentalists attempt to make it about S.S.

And people are expected to trust your judgment on politcal matters?

Naga Sadow|12.18.08 @ 11:40PM|#

Is Famous Mortimer an Edward/Lefiti clone or somethin'?

That's right Travis. I called him a clone. Big whoop. Wanna fight about it?

Noam Chomski|12.19.08 @ 1:35AM|#

Ich bin berliner

|12.19.08 @ 4:34AM|#

Your argument that regulation is bad because the SEC didn't do its job is flawed. You have neither demonstrated that a properly run regulatory agency could not do the job nor that the "free market" could do it better.

The SEC and other agencies like it exist to ensure that markets tend towards transparency. Over and over again reducing regulation on markets has reduced transparency. Reducing transparency causes the natural feedback loops in free market systems to extend amplifying booms and busts.

I think you need to get off your ideological pillar and start realizing that not all regulation is bad. Regulation that increases transparency is good. Regulation that limits the extent to which markets innovate is bad.

ed|12.19.08 @ 7:52AM|#

You fucking loony market fundamentalists [blah blah blah]...the case against evil capitalism [blah blah blah]...like religious fandamentalists panicking [blah blah blah]...


I have a theory that trolls type with their left hand while wanking with their right.
At the same time! It's quite a talent. Sideshow quality!

|12.19.08 @ 8:01AM|#

The more I think about it the more I think you're right Karl. The aggregate forms of investing like pension funds, money market accounts, index funds make a disconnect between good business and money invested. Instead of making money by investing in businesses that then make a profit from the capital invested, money is made from increased share prices because more money has been dumped into the market.

Gambling isn't a gain in productivity, it's just moving money around.

I wonder what would happen if you taxed dividends at 5% and capital gains at 50%?

Gilbert Martin|12.19.08 @ 9:08AM|#

"You fucking loony market fundamentalists really are worried about somebody making the case against evil capitalism"

Not really - since it is physically impossible to do so.

Fluffy|12.19.08 @ 12:19PM|#

I think a few points have to be made here, on both the pro and con side of libertarianism vis-a-vis this scandal.

On the pro side:

First, the SEC has over the last 20 years progessively increased its enforcement operations, in many cases pursuing novel prosecutions and more rigorous interpretations of securities law. You really can't chalk this one up to saying, "The Bush administration didn't want the SEC to do its job, and that's why this happened!" because the Bush SEC has been very aggressive. In addition, the scheme was of such long standing that it crosses over multiple administrations.

Second - and, I think, more importantly - in some respects the Madoff scandal is a case of regulatory capture. Madoff was able to break the rules precisely because he was an industry insider. His prestige was so high that his regulators would have been blinded by it. Regulators are human beings, and SEC regulators are looking for Ponzi schemers who are wearing gold chains and making phone calls from boiler rooms on Long Island, and don't recognize Ponzi schemers who are former chairmen of the Nasdaq. Some might say that a "properly designed" regulator would not suffer this weakness, but every experience I have ever had with regulators tells me the opposite. It's an information problem in some ways, too - a well-connected insider who straddles the private and public sector will always have the advantage over those attempting to regulate him.

Third, the presence of regulation tends to make customers assume that they are protected from the most outrageous schemes, as long as they deal with prominent industry figures. Someone with an operation as large as Madoff's "has" to be honest, because if he wasn't, the regulator would know - right?

On the con side:

Libertarians often assert that in the absence of regulation, markets would price in a trust premium. Investors would gravitate to firms with a reputation for honesty, and those firms would be able to offer lower yields than firms with less sterling reputations.

The problem is that the Madoff case shows that a schemer who devotes time to building an industry reputation can then turn around and use that very reputation as a tool of deception. People gave Madoff their money because they assumed they could trust him, due to his stature and prominence. In the absence of regulation, Madoff would have been precisely the guy investors who were seeking out a trustworthy firm would have gone to.

And he not only had stature, he had established a position of trust within the American Jewish community. In the absence of regulation, libertarians also claim that self-regulation affinity communities would serve as gatekeepers to exclude the dishonest. In this case, the opposite happened - once Madoff was inside the gate, members of the affinity community actually competed to give him their money.

It's also interesting that this con point is in some ways the mirror image of the second and third pro points. They're bound up together. So it's a complex question.

|12.19.08 @ 11:20PM|#

the only thing regulations accomplish is to undermine natural human instincts allowing for easy exploitation.

regulations make potential victims weaker and the con artist smarter. seems like a backward way to go about things. regulations also create perpetual cycle of more victims and of course more regulation.

there was a website not to long ago name 12dailypro. even with all the protections people continue to fall for these scams. i bet if you asked the people who fall for the african email scam they probably believe there is some government entity that would stop the email if it were a scam thereby making it more likely for a person to fall for the scam.

|12.20.08 @ 12:46AM|#

There's an apparent contradiction in the article, which says "The answer is not ... more rules ... government should also establish rules of the game ..."

Assuming one of the rules is "don't defraud investors", do regulators (or any justice department agents) have any responsibility to investigate allegations of fraud?
If they do, isn't that a "market intervention" that protects lazy investors?

I would think that any business soliciting investments would have an obligation to disclose their assets as a component of "informed consent" to any contract. Is that a "regulation", or a "rule" the author would support? It isn't clear from the article.

|12.20.08 @ 9:16AM|#

Ok, so let's take it down to brass tacks. The purported returns that Madoff generated were in the range of 10-14%, with the higher numbers in the boom years for real estate, Clintons, etc.

While that sounds like a lot, remember that most moneypundits tell us you can make those kinds of returns... on average... in the stock market. So where should the suspicion come from? The only thing would have been his annual audits, and hopefully a prospectus or some other communique from Dear Leader mapping out next year's strategy.

So really, the entire stock market is a giant ponzi scheme. Actually, the entire USA and it's economy are a ponzi scheme, and have been since the demise of rural farming. Your job? Part of the scheme. Education? Part of it (buy buy!). Your kids? The next victims.

So, since everyone here is talking about regulation vs. deregulation, I say we use a VERY deregulated approach to Mr. Madoff's sentencing and punishment.

I want ONE EYEBALL, that's it. I get to take a toothpick, go up to him, and stab it out of his face. There will be no regulation of my actions.

Paul A\'Barge|12.20.08 @ 11:56AM|#

Anthony Randazzo is wrong.

He sings a clever tune but in fact people who invest in operations run by others have a right to be protected from fraud. Not their own stupidity, but certainly from fraud.

The SEC was warned about the ponzi scheme and did nothing.

The fix is to make the SEC more effective at finding and eliminating fraud.

Thus, Anthony Randazzo is wrong.

|12.21.08 @ 12:36PM|#

Not that more regulation is actually a cure.....
But is the point of the article that we all have to loose a ton of money in a recession to find out who has been cheated out of all of it.

Montgomery Scott|12.21.08 @ 2:40PM|#

Here is an editorial submission to my local purveyor of 'news', the Idaho Statesman, regarding this subject.
As there is a limit of 200 words, I had to bring up as much as possible without details---

Bernard Madoff is being crucified for his $50 Billion Ponzi scheme. Where did he get the idea, and why didn't the SEC stop him?
Peter Schiff of Euro Pacific Capital points out that, "The Social Security Administration runs its 'trust funds' with precisely the same methods used by Madoff and Ponzi. As money is collected from current workers, the funds are then dispersed to those already receiving benefits. None of the funds collected are actually invested, so no investment returns are ever generated. Those currently paying into the system are expected to receive their returns based on the 'contribution' made by future workers."
To greater or lesser extents, the ENTIRE Federal Government is funded in this manner, and this is part of the answer for our current 'economic downturn', in which the banks are being 'bailed out', while the big three are being allowed to collapse to the point that they are being socialized by government.
If Ponzi is illegal, then outlaw the Federal Government!
Otherwise, leave Madoff alone-he was following the example of our 'leaders' in government.
Obama wants a one trillion 'stimulus'. Who is going to pay for it? Fed deficit this year approaching one trillion already--

|12.22.08 @ 2:10PM|#

Speaking of Florida investment schemes, the Granddaddy of All Florida Real Estate Swindles happened in the 1920. Crooked real estate developers sold millions of dollars worth of "prime development land" - ie., alligator-infested swamps - to gullible buyers. The Marx Bros. comedy Duck Soup of 1929 was loosely based on this event.

- Ironically, during breaks in filming Groucho Marxs burned the wires to his broker with buy orders, just weeks before the Great Crash. He lost his entire fortune. As he ruefully put it years later, "I lost my shirt, pants, socks and various unmentionable parts of my unmentionables that year."