December 21, 2008
The Madoff Ponzi Scheme
The Madoff Ponzi Scheme-Becker
The recently exposed Ponzi scheme by Bernard Madoff is named after Charles Ponzi, an immigrant to the United States, who ran his swindle in 1920, based supposedly on profits from postal reply coupons. He took in a great deal of money for those days that was partly spent on high living. After less than a year he was exposed by a newspaper, and spent many years in jail before being deported back to Italy.
In a Ponzi scheme, investors in a fund typically receive good rates of return on their investments for a while because they are paid with new monies that are invested in the fund. Even when such funds do not make bad investments, or when managers do not spend a lot on themselves and their families, Ponzi funds must attract new investors at a rapid rate in order to pay good returns to prior investors. With wasted spending and bad investments, the required growth rate in new monies is even higher. Since high growth rates of new investments are hard to maintain over time, eventually Ponzi funds collapse. Then comes the day of reckoning as investors are shocked to discover that they have been duped, and have lost most or all of what they invested.
Ponzi-type swindles probably go back to Greek and Roman times Over 50 years ago I had a wealthy uncle who invested with an individual who seemed to be doing remarkably well with a secretive investment strategy: he paid high returns in the form of monthly dividends, and allowed people to withdraw their investments. My uncle not only increased his investment, but advised other family members and friends to do the same (my father was either smart or lucky enough not to do so). After a couple of years the manager vanished, and investors lost all they had given him. It turned out that he was paying these good dividends not from returns on his investments, but from the new funds he was raising- a typical Ponzi scheme. While he did not lose most of his considerable wealth, my uncle went into a year-long depression after he found out he had been "taken".
What was unusual about Madoff's swindle is that it continued for over two decades, and was the largest Ponzi scheme ever uncovered, with perhaps $50 billion lost or missing. It was also the first fully international Ponzi scheme, with investors from Europe, the Middle East, and China, as well as mainly from the US. One hedge fund, the Fairfield Greenwich Group, put over $7 billion into Madoff's fund, and encouraged others to invest in it as well. Bernard Madoff is a 70 year old apparently affable but retiring, person who did not live especially lavishly. He was very active in Jewish circles, so that, many of his investors were wealthy Jews, such as Jeffrey Katzenberg, Steven Spielberg, and Mortimer Zuckerman, and Jewish organizations, including the Eli Weisel Foundation and Yeshiva University.
The enormous scope of Madoff's swindle raises two obvious questions 1) how could this scheme go on for so long without being exposed, and 2) how could so many sophisticated individuals be taken in by a fund that provided almost no information on how it was able to achieve consistent returns of from 8-13 per cent for many years during both good and bad times?
In regard to the first question, various hedge fund managers were puzzled by how Madoff could make such consistently high returns with the information provided about what he did. Apparently, one claim was that he placed both put and call options on say the S&P 100 index. That might make money when stocks are falling rapidly, but the fund should have lost money on average during the mainly good years of the scheme's existence. One former hedge fund manager, Harry Markopolos, reported him for a decade to the SEC and also to state regulatory bodies. The SEC conducted some rather superficial investigations, but nothing much came of them-the SEC is now looking into why the swindle was not discovered much earlier. I believe this is another illustration of what has happened frequently, namely, that regulators too get caught in the hype surrounding an investor, or the economic viability of different banks.
Of course, it is well documented that after a catastrophic event, many "obvious" signs are discovered that if taken seriously could have prevented the event. For example, after 9/11 it was revealed that the FBI did not investigate carefully warnings that some major terrorist act was being planned. This was also the case with the Japanese attack on Pearl Harbor. Roberta Wohlstetter in her outstanding book, Pearl Harbor: Warning and Decision, explains why the Japanese plan to attack Pearl Harbor was not discovered despite the considerable prior intelligence about their plans for an attack.
This is also the case with the Madoff swindle, which makes it more puzzling. Why did many sophisticated individuals, funds, and other organizations entrust so much money to his management, and to management by various intermediaries, without doing any significant amount of due diligence? Part of the answer is that these individuals are not sophisticated in financial matters, and each successive set of investors assumed that previous investors had done some investigation. This led to an example of "information cascades", where private information is revealed sequentially over time to different individuals. Later participants can be badly misled if the information of earlier participants is far from accurate.
Moreover, Madoff had developed an outstanding reputation. He was a respected member of the financial community and exclusive social circles, and a former president of the Nasdaq Stock Market. He helped pioneer electronic trading of stocks, and continued this profitable stock trading business while independently building up his asset management business. He did not let everyone invest with him, so that those who were accepted felt privileged. His activities went on for so long without exposure that newer and older investors alike considered his investments to be legitimate, even if secretive. He bolstered his clients' confidence by quickly refunding investments to anyone who asked.
Stock markets are not fully efficient, and a small number of investors, such as Warren Buffet, can consistently do better than the major indices over very long time periods. However, markets are sufficiently efficient that such a record is extremely difficult to maintain. It takes very many years to establish a good investment track record that is due to skill instead of a good record due to plain luck. The numerous investors not well versed in financial matters have great difficulty appreciating that there are no magical or secretive ways to consistently beat the market. This is why when anyone asks me for advice, I recommend buying a diversified portfolio of stocks and other assets that controls risk while providing decent returns. Some money managers may be able to beat that in the long run, but it is extremely difficult to discover who they are. As a result, most investors looking for exceptional returns are likely to be taken for a ride either by charlatans, or by lucky fund managers whose luck eventually runs out.
Bernard Madoff and Ponzi Schemes--Posner's Comment
I must be cautious in discussing the Madoff scandal because as a judge I am forbidden to make a public comment on pending or impending litigation. Madoff himself of course has been arrested, and already lawsuits have been filed against some of the "funds of funds" that steered investors' money to him. I shall proceed on the assumption that the media are correct in describing Madoff as the author of a Ponzi scheme--indeed he is reputed to have described it that way himself--but I shall treat it strictly as an assumption, a hypothesis, and not as established fact, which is for a court to determine. And I will not comment at all on the suits against the funds of funds.
It is unsurprising that a Ponzi scheme should come to light during a stock market crash. As Warren Buffet is reputed to have said, one doesn't know who is swimming naked until the tide runs out. The stock market crash would have reduced any remaining assets in Madoff's investment account at the same time that liquidity problems caused by the depression would have increased the rate of redemptions.
Madoff's scheme, as described in the media (and remember that I am not taking a position on the truth of any of the allegations that have been made against him), is not a classic Ponzi scheme. The classic scheme is a "con" in the sense of a fraud perpetrated against greedy dopes. A skillful con man uses his gift of salesmanship to inveigle people by such ludicrous pitches that only the least sophisticated, or those most blinded by greed, are conned. A typical Ponzi scheme might offer a 10 percent monthly return on investment--the very improbability that such an offer could be genuine assures that only suckers will invest and they are least likely to discover that they have been conned until the con man has made a bundle. They may never discover that they have been conned--they may be convinced by the con man that they lost their money because of a legitmate business failure. Or they may be embarrassed to complain, or even afraid to complain because they suspect that they've been involved with a criminal enterprise--what but a criminal enterprise could generate a 10 percent monthly return on one's investment? It is possible therefore that many Ponzi schemes are never reported to the authorities and hence never detected.
The strategy that has been attributed to Madoff is the opposite of that of the typical Ponzi schemer: it is to obtain investments from well-off people far more financially sophisticated than the average Ponzi victim, including genuine financial experts such as hedge fund managers and bank officials. And therefore it requires different tactics from that of the ordinary Ponzi scheme, such as offering returns only moderately above average, satisfying redemption requests promptly, turning down some would-be investors (it would be interesting to know whether there was a tendency to turn down investors who might prove nosy or suspicious), and trading on a reputation earned in a legitimate business (Madoff's business of market making). Madoff is alleged to have preyed primarily on his fellow Jews; such "affinity" frauds are common, because people are likely to be more trusting of members of their own ethnic or religious group than of outsiders and because a con man may be abler to identify and exploit the weaknesses of members of his own group than of others.
The most interesting question raised by the scandal is why though it apparently continued for decades it was never detected by the Securities and Exchange Commission, even though beginning eight years ago a money manager named Harry Markopolos began bombarding the Commission with letters accusing Madoff of operating a Ponzi scheme. (The fact that Madoff did not sue Markopolos for libel should have been another warning sign.) There are two hypotheses. One is that regulation is hopelessly inefficient, and that it should be up to investors to protect themselves as best they can against securities frauds. The SEC's budget was increased substantially in 2004 in reaction to its failure to have detected the Enron, World Com, and other financial scandals that erupted in the early years of the new century, yet it still failed to detect Madoff's scheme. The other hypothesis is that under Chairman Christopher Cox (as under the first chairman appointed by President Bush, Harvey Pitt), the SEC has been too trusting of the securities industry, as part of a general philosophy of deregulation, small government, and laissez-faire that has characterized the Bush Administration. The SEC does seem to have been asleep at the switch quite a bit of late. Just days before the collapse of Bear Stearns marked the beginning of the banking crisis, Chairman Cox said that "We have a good deal of comfort about the capital cushions at these firms at the moment." In fact most of the firms about which he was speaking--the investment banks--were teetering at the brink, and in some cases over the brink, of insolvency.
Cox's reaction to the Madoff scandal has been to blame his subordinates in the Commission, rather than to take responsibility himself. That is not an endearing reaction.
The standard governmental response to a major governmental failure is reorganization. The government wants to prove that it is doing something to prevent a repetition of the failure, and the cheapest yet most visible and dramatic way to show that it has "gotten the message" and is going to "do something" is to reorganize. Hence the creation of the Department of Homeland Security and the Directorate of National Intelligence in the wake of the 9/11 attacks. It is beginning to seem likely that there will be an ambitious reorganization of the financial regulatory system. In the course of that reorganization, the SEC may be abolished. If so, Bernard Madoff and Christopher Cox can share the credit.