The Perfect Ponzi

At the time of this writing, the Bernie Madoff story is the most popular topic in America. A quick Google search reveals countless newspaper, magazine, and on-air stories that have used his record-breaking “$50 billion” Ponzi scheme as a lead-in to what’s wrong with everything from Wall Street to capitalism to Social Security to the

Bush Administration (which is a good trick, considering that Madoff is a leading New York Democrat, reportedly contributing heavily to Hillary Clinton, Charles Schumer, and Chris Dodd, among others).

First, let’s talk about what we know of Madoff’s crimes, which to date is very little. Apparently, in early December, he held a meeting in his New York penthouse with two “key employees” who were reportedly his sons. Madoff told them that his decades-old, highly successful investment management business was a fraud, “a Ponzi scheme” in fact, and that he couldn’t keep it going any longer. The sons went directly to the FBI and ratted out the father, who, when subsequently visited by a pair of Special Agents, admitted his investment portfolio was a sham, that there were never any “returns,” and that over the years, he’d lost around $50 billion of investor money.

FINRA documents show that Madoff was supposed to have $17.5 billion under management in December. Sources say that some 25 or so investors–which include some of the largest and most sophisticated institutions, hedge funds, pensions, charities, and private investors in the world–had contributed around $36 billion. Judging from Madoff’s alleged (and clearly deluded) statement to his sons that he planned to distribute the remaining $200 million to $300 million to employees, family, and friends, there’s little left in his investment portfolios.

How Did He Get Away With It?

To get a handle on the Madoff mess, the key question is: How did he get away with this scam for so long? One of the hedge funds with which Madoff perpetrated his alleged fraud–Fairfield Sentry Ltd–was started in 1990, “returning” an average 10.5% annually since then. (Others of his multi-billion dollar funds returned 15% a year or more.) Using Madoff’s own $50 billion figure, this has been widely reported as the largest Ponzi Scheme in history, but to my mind the greater significance is that it’s also probably the longest-running Ponzi, as well.

We may never know whether Madoff ran it as a scam from day one, or whether, like most Ponzis, it started as a legitimate investment fund that had some bad years, which Madoff smoothed out by using new investors’ principal to pay fictitious returns to existing investors, expecting to pay the money back out of better returns in subsequent years. When those returns didn’t materialize, he found more new investors whose money went to pay the older investors again, starting the downward cycle for which Charles Ponzi is known.

The problem with Ponzi schemes is that they require an ever-expanding base of new investor capital from which to pay “returns” to the growing stable of existing investors, but sooner or later, the pyramid will collapse. Unless the perpetrator plans to flee to a well-padded nest with no extradition treaty with the United States, he or she is going to get caught, and probably do some jail time. But 20 years is, as far as I can tell, a record-breaking time to keep such a fraud going.

How did Madoff pull it off? I believe he combined two elements to create the “Perfect Ponzi,” if we can use that term for a guy who’s probably facing prison for the rest of his life. The first factor (and you just gotta love this part) is that despite many red flags over many years, his investors didn’t pull the plug because they thought his phenomenally consistent returns were coming from insider trading–AND THEY WERE OKAY WITH THAT!

What most news stories haven’t reported is that the investment management business was just a sideline for Madoff, who founded and owned one of the largest investment trading and market making houses in New York, matching sellers with buyers on leading exchanges around the world. By his own account in a digitally recorded interview (http://curiouscapitalist.blogs.time.com/2008/12/15/me-and-bernie-madoff-on-video-abridged), Bernard L. Madoff Investment Securities, LLC handled $1 trillion in trades a year, and is one of the top three market makers in both NYSE and Nasdaq securities.

Is it possible that at least some of his investors believed he was using his investment funds to front-run the trades BMIS was making for other investors (that is, he’d monitor the trades for large purchases or sales, then buy or sell the securities first, locking in a sure profit when the larger transaction was executed a few seconds later)? Henry Blodgett on clusterstock.com recently reported: “For years and years I’ve heard people say that [Bernie's] investment performance was too good to be true… and too high given the supposed strategy. One Madoff investor, himself a legend, told me that Madoff’s performance ‘just doesn’t make sense. The numbers can’t be straight.’ So why did these smart and skeptical investors keep investing? They, like many Madoff investors, assumed Madoff was somehow illegally trading on information from his market-making business for their benefit.”