It is being called several different things, from a Ponzi scheme to a pyramid scheme. One thing is certain: it is perhaps the biggest single confidence scam ever perpetrated by one man. You have probably never heard of him before, but as of last Thursday, the world knows him all too well.
His name is Bernard Madoff. (This link was active on Sunday, but as of Monday morning it is now just this one-page statement.) And like the vast majority of you, I had never heard of him prior to this past Thursday. That is when reports came out that Mr. Madoff was arrested by US Federal agents for what the Securities and Exchange Commission is describing as “fraud for a multi-billion dollar Ponzi scheme that he perpetrated on advisory clients of his firm.”
What is a Ponzi scheme? Thanks to our friends over at PyramidSchemeAlert.org:
Ponzi schemes, named for 1920s American Charles Ponzi, enrich early investors at the expense of latecomers. Payments to original investors are typically made using money generated by finding new people to buy in to the business. Later investors eventually run out of fresh recruits to the scheme — and with no other source of revenue, the “pyramid” finally collapses.
And what was the total bill for this fraud? It depends on who you talk to, and the dust is still settling, but the reports are that fifty billion dollars ($50,000,000,000.00 US) has been lost at the hands of Madoff. Some estimates say it could go higher, and some think it might be lower. But it is definitely in the billions, and if it is, say, fifty billion dollars or higher, then I can’t think of another way to describe it other than it being the greatest financial con job in history.
There are numerous articles to be found online that are following the story. Here is The Wall Street Journal page – a whole page devoted just to this case. Geographically speaking, this crime hit somewhat close to home for us at The New England Skeptical Society. Several companies based here in Connecticut are in for some very large sums of money with Madoff. One company in particular, Maxam Capital Management in Darien, CT, reportedly lost two hundred eighty million dollars. The company is finished. Several individuals, all Connecticut residents, all ultra-wealthy, and some of notoriety and name recognition, are also some of the victims of this massive fraud.
To try and get a better grasp of what actually happened in this case, I spoke yesterday with Gene Qualman, financial advisor for Able & Company based in Darien, CT. Gene was able to sum up the case for me better than I could research and report to you:
Evan: Is it correct to describe the Madoff case as a Ponzi scheme?
Gene: His wasn’t really a true Ponzi scheme. A true Ponzi scheme is where a crook cons investors out of money by promising returns on a short term basis, but pays the so-called “returns” using other people’s money. For example, if you give me a thousand dollars, I’ll tell you that I will give you back twelve-hundred dollars in a month. Tell that to a bunch of people, so the first ones coming in get paid by using moneys coming in form the next investors. The first investors do get paid, but they are not really making a yield on their investment. They are using the next group of investor’s principal to pay a phony return. By definition, this will eventually fail and collapse. What happens is that as more and more people get in on the deal, thinking they’ve got a good thing going, the base of people that you are obligated to pay grows, you run out of money to pay out, and it collapses.
Evan: What made Madoff’s scheme different?
Gene: What Madoff did was a little different. He didn’t promise short term big gains. He said that he’ll do the best he can. It was a brilliant scheme. He turned people away, making him a more believable character. What he said was that I’ll invest your money and do my best with it. He did not promise a return. His so-called funds and investments, as time went on year after year, consistently averaged 12% to 16% returns. Even in years when most of the competing funds made little or no money, his still reported high returns. His fund gave consistent, well above average returns. Madoff encouraged certain investors, incredibly well off people, who didn’t immediately need the money, so he was not as vulnerable to people saying “give me all of my money back.” This gave him a wider base to pull from. By comparison, in a classic Ponzi scheme, people are looking to get their investment back in a much shorter period of time. His technique is more accurately called “Robbing Peter to pay Paul.” It is a modified Ponzi scheme.
What got him caught is that the current problems with the economy have been so devastating that he had to ultimately confess. My understanding is that many hedge funds are getting calls for redemptions – meaning investors looking to make very large or complete withdrawals form the funds. Madoff got calls for seven billion dollars in redemptions, and he had almost nothing left to give them. I’m not sure it will end up being fifty billion dollars because I think that number is an estimate which includes all the estimated accumulated rates of return he made over a period of time. Supposedly, an investor’s account earned money and then they would reinvest those profits, accumulating year after year. Some people would get checks or payouts once a year and very few people asked for all their money back. He had enough to get by, but lately, the demand for redemptions have been so huge that it caught up to him at this time.
Evan: How was Madoff able to pull it off for so long without getting caught or having it collapse sooner than it did?
Gene: What Madoff did was to insist that when people give him the money, they give him what is known as “custody” of the funds. He was also allowed to do “internal reporting”, and he insisted on “clearing his own trades.” These are all dangerous signs. If you are going to give your money to anyone who insists on these three conditions, don’t do it. “Clearing his own trades” means that there is no outside way to double check him. “Custody” means he can co-mingle funds. I always tell my clients to make sure they make them their own account. You get a monthly statement held by an outside authority, so you can see what is really going on. But when you get into these issues of what Madoff was doing, such as co-mingling money, you are ripe for the picking. Money comes in, you have no clue what happens to it. He’ll give you a report, but where is the authority to double check it to make sure it is correct?
Evan: Who was supposed to be watching and checking on Madoff?
Gene: The other thing that is going to be interesting to follow is that the firm he used to audit his work, that was supposed to be a last-gap clearance to check his work, was not there. He supposedly had this outside auditor that supposedly gave a statement each year saying things were ok. But obviously, things were not ok. So the question is why did he get the clearance? I believe there will be other people implicated in this. Based on the scale and magnitude of this, it is almost impossible that one person could have done all this alone.
There are lots of smart people in the industry that did not get involved in this person. Now that they are being polled, they did not think he was doing some kind of Ponzi scheme, but rather they thought he was doing something called “front running.” Front running is an illegal technique as well, but it happens. If you are doing trades for people, and suddenly, one day at 9am, you get many of your clients saying “sell XYZ company”, you know then that lots of orders are about to come in for sales. So what you would do is to short sell XYZ Company, and THEN place their orders, and it brings the price down even lower. That’s front running, and it is totally illegal. Ironically, the folks that did not want to get involved with him thought this was how he was making his yields. In reality, he was not making a yield of any kind.
The irony here is that he managed to get away with it for so long, at the magnitude he did, against the pool of incredibly intelligent, wealthy, and established investors who trusted him. There did not seem to be any checks and balances along the way.
Evan: How much did his personality have to do with his success?
Gene: His personality, and his reputation, had quite a lot to do with his scam. He used to run NASDAQ, so he has a reputation of trustworthiness. The way he did it was very smart. He did not pressure people. Many well known people were pushing for him (vouching for him) and he turned several people away for a variety of reasons, not the least of which to help create an air of legitimacy. When they asked him how he was consistently able to make this well above average rate of return, he made up a term that people didn’t understand. They assumed it was just his own secret formula. No one questioned him any further.
Evan: We’re not far from the epicenter of Madoff’s crimes.
Gene: The loss in pension funds for those based in Fairfield County (CT) is out about forty two million dollars. Reportedly, there is a hedge fund here in Darien, CT that lost two hundred eighty million dollars.
Evan: What needs to happen to better protect people from these con artists?
Gene: Madoff either wasn’t policed enough, or he had such a clever way of recording his dealings that it got by the authorities. The SEC and other local agencies similar to them, such as the Connecticut Banking Commission, are just too short handed. Their case load is huge. They typically have only three days to do three weeks work of work. It is no that they are lax or careless. They just don’t have the manpower. These agencies need much more funding for auditing. This is a real good way to protect people.
Evan: Now that this one has become exposed, what can we expect in the future?
Gene: If authorities had the time to look at certain hedge funds, they will find out that variations on these scams have occurred. Probably not as skilled or involved as this one, but this could be the next leg of the financial industry that gets rocked to the core. (end interview)
These measures, and then some, are echoed more abruptly and loudly by Robert Fitzpatrick at Pyramid Scheme Alert. Robert has made it his life long mission to do everything he can to alert everyone to the dangers of the Bernard Madoff’s of the world. The bottom line is that schemes can effect anyone, of any intelligence, any social status, from all walks of life. By using some of the tools in our skeptical toolkit, we might be able to better protect ourselves, our families, and our businesses when making big economic decisions – especially nowadays.