Bernard Madoff: More Trouble on Wall Street

Related Links: Forbes: Lessons for Madoff Investors WSJ: Why We Keep Falling for Investor Scams WSJ: Document: Submission to the SEC (PDF download) WSJ: Document: Case Closing Recommendation (PDF download)

On December 12, 2008, Bernard L. Madoff was arrested on a single count of securities fraud, carrying a possible sentence of up to 20 years in prison and a maximum fine of $5 million.

The media reported that, on the evening of December 10, Madoff disclosed to his two sons, high ranking employees of his trading firm, Bernard L. Madoff Investment Securities, the stunning news: that he was “finished” and that his firm was insolvent, the inevitable end of a pyramid scheme that was “all just one big lie.”

The losses Madoff created for investors, by his own admission estimated at up to $50 billion, is said to be the biggest fraud committed in the history of Wall Street.

The Man and His Ascendancy

Bernard L. Madoff, a pioneer of electronic trading and a former chairman of NASDAQ (National Association of Securities Dealers Automated Quotations), the largest electronic equity trading market in the United States, may have only recently become a household name, but he was well-known on Wall Street for decades.  Madoff founded his investment securities firm in 1960, with an initial investment of $5,000 he saved while working as a lifeguard and installer of sprinkler systems in east Queens.

Over the years, Madoff’s firm grew to be one of NASDAQ’s largest traders of securities, buying and selling securities through its hundreds of traders.  Madoff’s firm operated as a securities broker-dealer, an entity that charges transaction fees and/or commissions for trading securities on the open market.  It also had an investment advisory arm, which advised clients about investments and directly managed funds, amounting to $17 billion according to federal prosecutors.  In addition, the firm had ties with what are known as “feeder funds,” run by other managers, a number of them well-known on Wall Street.

Too Good to Be True

Madoff’s firm offered what most investors seek – low risk and high returns.  This should have fallen under the “too good to be true” category, as these concepts are fundamentally at odds. Red flags should have been heeded by investors who saw that no other investment firms were able to match or even come close to the performance of Madoff’s investments.  In general, investors accept tradeoffs along a scale of returns, with progressively higher returns generating correspondingly higher risk.  In both up and down years, however, investments made by Madoff’s firm returned its clients between 12 and 13%, an unusually steady rate, like clockwork.

That unusual record created some doubt and concern among Wall Street advisors, hedge funds, and other potential investors, as well as competitors, most of whom could make very little sense of the complex, ambiguous statements the firm routinely sent investors.  But it also managed to attract a large and devoted group of investors looking for steady — and, unfortunately for them, only apparently secure – returns.

Madoff moved in affluent circles, finding clients through contacts at country clubs in New York and Florida.  His clients included high-profile individuals such as director Steven Spielberg, producer Jeffrey Katzenberg, New York Mets owner Fred Wilpon and former owner of the Philadelphia Eagles, Norman Braman.  Madoff also had a number of institutional investors, including French bank BNP Paribas, Spanish Grupo Santander SA, British HSBC Holdings PLC, Japanese Nomura Holdings, as well as Credit Suisse, which apparently invested just under $1 billion, and the hedge fund Fairfield Greenwich group, which is said to have invested the staggering sum of $7 billion.  The list of high-profile investors adds to the scale and scope of Madoff’s fraud, which also spread to Europe, the Middle East, and China.

Closer to home, Madoff’s investors also included those who could ill-afford the losses now inflicted on them, including small-time investors and as many as 50 charities, a number of them Jewish organizations that either invested with Madoff personally or were supported by the foundation he and his wife set up.  Many of those investors and organizations are now scrambling to replace lost assets and income after the fallout from the Madoff’s scandal, compounded in many cases by the economic downturn.

An Amazing Ponzi Scheme

Recent events revealed Madoff’s financial strategy as little more than a pyramid scheme, or a “Ponzi Scheme,” as it has become known.  The structure is named after Charles Ponzi, who created the first such scheme in the 1920’s by selling investments that were said to generate healthy returns but were actually paid out from the funds brought in by new investors.

Ponzi schemes generate an unsustainable cycle of acquisitions and redemptions.  The balance sheet graphics below help illustrate what a Ponzi scheme looks like. Balance sheets depict what a company owns and what it owes.  Let’s first look at a “normal” balance sheet, and then one of a Ponzi scheme.

“Normal” Balance Sheet

In the case of an investment firm, for example, the “own” part of the balance sheet includes the investments the company makes and any cash it has on hand.  The client deposits are the “owe” part of the balance sheet (the company owes its clients the deposits).  In a non fraudulent company, the investments (own) would grow, and so the “worth” would grow.

Ponzi Scheme Balance Sheet

But, a Ponzi scheme balance sheet ends up looking like this:

In this example,  the categories have the same meaning, but the cash and investments (own) are not growing as fast  (or at all) as the Ponzi scheme purports.  Cash is depleted to pay for the promised returns to clients.  In order to keep going, the Ponzi scheme must attract new client deposits to artificially prop up the investments section of the balance sheet so that ,  the new cash can be used to pay the “returns from the investments” to earlier investors.  In reality, however, the “own” section of the balance sheet is going down, and therefore the “worth” is also going down, eventually slipping into negative territory.  The result is a constant need for cash, which puts pressure on the firm to attract greater and greater investments at an increasingly rapid rate to pay out those investors seeking redemptions.

It’s not difficult to see that Ponzi schemes eventually run into trouble.  The cycle stops and the scheme collapses when redemptions exceed assets, which turned out to be Madoff’s downfall: the recent economic downturn generated more redemptions than his firm could afford to pay out, which led to his confession to his sons on the evening of December 10.  What is remarkable about Madoff’s firm is how it stayed in business for decades, while Ponzi’s original scheme, for instance, was discovered within a year.

How He Fooled Them

Part of the explanation no doubt lies in the following that Madoff was able to develop, attracting affluent clients, even turning away a number, which added to his mystique.  Part of it also lies in what economists call an “information cascade,” whereby information about a fund’s investments and viability are passed along from investor to investor, eventually comprising nothing more than hearsay or second-hand information.  The process has the potential of greatly enhancing an individual’s or firm’s reputation while, at the same time, dramatically reducing due diligence.  Several clients of Madoff’s report never being able to speak to Madoff himself after having invested their money with him.  Madoff’s Ponzi scheme and others like it rely on this process to keep investments coming, a process we might call the information equivalent to the financial pyramid sustaining it.

Others Were Not Fooled, But the SEC Didn’t Listen

One hedge fund manager and derivatives expert, Harry Markopolos, reported what he viewed as Madoff’s unsustainable gains to the SEC and state regulatory agencies for a decade leading up to the debacle, with little or no result. In one communication, a seventeen page letter sent to the SEC on November 7, 2005, Harry Markopolos stated his belief that it was impossible for Madoff’s investment results to have been obtained by any other means then fraud. He described two possible scenarios that explain the only ways Madoff could have obtained the results, both fraudulent. In the letter he details his observations and spells out in detail a list of 29 “red flags.”  Here is a summary of four points that were brought to the attention of the SEC in the letter.

1. Structure: Madoff didn’t directly invest money for his clients, fund managers and financial advisors.  He sold them through 15 or more so-called feeder “Funds of Funds,” which sold the investments under their own names and then passed on the money invested to Madoff’s firm.  The firm then charged a commission (as broker) as well as a “principal fee” (as agent).  The disclosed charges amounted to several percentage points, and didn’t include the customary hedge fund charge of a large share of profits, often around 20%.  Such an unusual structure — which, in addition, seems a bad deal for the firm — bears scrutiny, and caution.

2. Secrecy: Very little of the above, or indeed of Madoff’s purported investment techniques, were ever revealed to anyone outside Madoff’s close circle of firm higher-ups.  Even those who invested with Madoff were told that the firm’s strategy was proprietary, and the financial statements of their clients suggested a hopelessly complex strategy with few, if any, particulars.  The secrecy in which Madoff’s investment strategy was held was legendary.  Such an unusual level of secrecy, once again, suggests a cover-up.

3. Consistency: Madoff’s numbers were too consistently good to be true.  The letter to the SEC quotes the occurrence of only 7 monthly losses (all small) in 14.5 years for the Fairfield Sentry fund, all with an overall return of 12% (equivalent to the general average of equity, or stock, investments in the broader market!)  Such a record was unmatched by any other Wall Street firm and is atypical of a low risk investment.  The numbers were so inconceivably steady, in fact, that the letter (dated three years before the scandal was exposed) pointed to one of two conclusions: either Madoff was trading on inside information, or the whole operation was a classic Ponzi scheme. 

4. Mania: With numbers like that, everyone wanted in on the game.  And Madoff stoked the fire of social pressure.  He claimed that his fund would soon need to close.  And word spread.  People began joining country clubs he was a member of, for the sole purpose of the privilege of investing with him.  And Madoff turned a number of them away, although quite a few investors and a suspiciously large number of fund managers, claimed to be one of the lucky “few.”

How They Got Duped

Of course, not all of these signs are obvious to the average investor.  The financial details, after all, were discovered by a financial expert.  And a number of other “experts” were duped along the way.  But the psychological factors — secrecy; a wide-scale, irrational mania; and a general smell of “too good to be true” — all pervaded Madoff’s dealings.  Although it’s easy to see them in hindsight, the combination of factors should, at least, serve as red flags.  (A recent New York Times op-ed article reaches a similar conclusion.) 

The SEC Responds With A Slap on the Hand

Sparked by Markopolos’ decade long effort to expose Madoff’s fraud, in January 2006, according to the Wall Street Journal, the SEC opened an investigation into Madoff and “found that Mr. Madoff personally ‘misled the examination staff about the nature of the strategy’ used by the Fairfield funds (an investment fund that had close ties to Bernard Madoff) and other hedge-fund accounts, and also ‘withheld from the examination staff information about certain of these customers’ accounts.’ The case was eventually closed as the violations were deemed minor.

The House Financial Services subcommittee has been holding hearings to discover whether the SEC (Securities and Exchange Commission), which conducted preliminary investigations over the last several decades, had enough resources to discover the truth about Madoff’s investments.  Such revelations also have the subcommittee asking whether the SEC properly followed up on these and similar leads and, if it did, why it didn’t act on them.

Is There Help for Those Who Lost?

In the meantime, there may be some help available to investors.  U.S District Judge Louis L. Stanton is asking those who lost money with Madoff to apply for relief under a federal statute established for the purpose.  The SIPC (Securities Investor Protection Corporation) may also be available to make investors whole, although (much like the FDIC, which protects bank deposits) it offers only limited protection — up to $500,000 of losses per investor, of which only $100,000 may be in the form of cash.

There may also be some tax relief for investors, under an IRS theft loss provision, which can be applied to the current tax year and the three years prior, as well as carried forward for up to 20 years.  In addition, it may be possible to reclaim the taxes paid on overstated gains from Madoff investments.  These and other avenues are complicated, however, and require expert tax help and advice.  And it is entirely likely that any federal protections and incremental tax advantages will do little to stem the tide of losses and general shock the Madoff scandal has left in its wake.

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