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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."
Posted by Tyler Cowen on December 13, 2008 at 07:51 AM in Economics | Permalink
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.
Posted by: Michael Salfino at Dec 13, 2008 8:36:15 AM
What do you mean "an unregulated hedge fund could not have done the same. This was an unregulated hedge fund.
Posted by: meter at Dec 13, 2008 8:52:31 AM
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.
Posted by: Dennis Mangan at Dec 13, 2008 8:58:32 AM
"and now grandmothers have been fleeced"???
More like the idle rich.
Posted by: Jason at Dec 13, 2008 9:43:02 AM
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?
Posted by: greg at Dec 13, 2008 9:47:32 AM
Robert Wenzel has been following the story of how behind-the-curve the SEC was in all of this. Apparently one guy was writing letters to them from 1999 saying this was a Ponzi scheme and they should investigate. And there were some private firms that wouldn't deal with anybody who was intertwined with Madoff, because his operation had so many red flags. See here, here, and here.
But, at least the SEC is cracking down on Mark Cuban and short-selling.
Posted by: Bob Murphy at Dec 13, 2008 10:31:18 AM
Jason, a lot of grandmothers *are* the idle rich.
Posted by: Tyler Cowen at Dec 13, 2008 11:33:53 AM
So is Madoff a philanthropist because he's a crook (better to dupe the clients) or a crook because he's a philanthropist? Alot like Alberto Vilar.
Posted by: bjk at Dec 13, 2008 11:37:52 AM
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."
Posted by: Greg Ransom at Dec 13, 2008 12:56:16 PM
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."
Posted by: Greg Ransom at Dec 13, 2008 12:58:36 PM
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').
Posted by: bruce at Dec 13, 2008 1:20:02 PM
I think that a professional economist with behavioral leanings should be able to explain why: a) individual investors saw a picture of reasonable but consistent returns with minimal deviation, and b) these same investors thought that the picture showed little risk, as opposed to depicting a falsehood.
Looking forward to an explanation.
Posted by: michael webster at Dec 13, 2008 2:55:37 PM
When an individual does this it is called a crime -and it is. When the government does it it, is called Social Security.
Posted by: at Dec 13, 2008 3:00:13 PM
When an individual does this it is called a crime. When the government does it, it is called Social Security.
Posted by: at Dec 13, 2008 3:03:37 PM
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.
Posted by: at Dec 13, 2008 3:05:21 PM
Jason, a lot of grandmothers *are* the idle rich.
My grandmother was until she died. I've met and know a few grandmothers who fit that description, and almost all were/are sweet little old ladies who outlived their husbands, husbands who for the most part worked hard and saved and invested. No inheritances.
But then they're just the idle rich.
Envy and covetousness are not admirable qualities. And class warriors aren't so admirable either.
Sheesh.
Posted by: at Dec 13, 2008 3:45:55 PM
"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.
Posted by: meter at Dec 13, 2008 4:36:34 PM
Laugh your ass off. The head of GMAC was an investor in Madoff's Ponzi scheme. Send my tax dollars to _that guy_.
Posted by: Greg Ransom at Dec 13, 2008 5:00:51 PM
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.
Posted by: Sydney at Dec 13, 2008 5:27:45 PM
I do not understand. Why was this a Ponzi scheme and not a bucket shop?
Posted by: Paul Johnson at Dec 13, 2008 6:03:33 PM
"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.
Posted by: MW at Dec 13, 2008 6:07:49 PM
"I'm actually surprised there are not "professional wager advisors" in Vegas"
Actually, there are, at least for sports betting. The scam works like this: The "sports handicapper" starts out with a large pool of suckers and tells half his clients that one team is going to win, and the other half that the other team is going to win. Whichever team wins, he calls the clients he told to bet that team and sells them the next pick, again, half get one team, half get the other. He keeps repeating this process with each game until he has winnowed down his clients to a group that he has given the "correct" pick for every game and they are now willing to pay him ANYTHING to get the next pick, because they believe they will make all the money back and then some by betting based on his picks.
Posted by: Jacqueline at Dec 13, 2008 6:08:19 PM
So, maybe there are good reasons for the current liquidity crisis?
As J.K. Galbraith said, recessions uncover what auditors miss.
Posted by: Steve Sailer at Dec 13, 2008 6:42:48 PM
When we end the myth of Social Security as an investment...
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."
Posted by: Derek Scruggs at Dec 13, 2008 7:15:53 PM
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.
Posted by: ogmb at Dec 13, 2008 7:57:16 PM
