The Madoff Story

Contributed by Martin Mitchell, director of eLearning for the Corporate Training Group

The press is peppered with references to Bernard Madoff’s $50bn ‘Ponzi’ scheme, and this article attempts to cover the what, why and how of the scheme.

First a bit of background – the term Ponzi scheme dates back to a particular individual, Charles Ponzi, who fooled thousands of US residents into investing in a postage speculation scheme back in the 1920s. Ponzi told investors that he could double their funds in three months, by using their money to buy and sell international mail coupons. It was marketed as an arbitrage scheme that would buy the coupons where they were relatively cheap (in Italy) and sell them where they were relatively expensive (in the US). The promised returns saw him inundated with funds, including the staggering statistic for 1921 of taking in $1m in a 3-hour period. A few early investors were paid off to make the scheme look legitimate, but a subsequent investigation found that Ponzi had only purchased about $30 worth of the international mail coupons. Ponzi was jailed, but had enjoyed a very comfortable living for a time including an air conditioned mansion with heated swimming pool.

From that point on, a Ponzi scheme became the term for a scheme that works on a “rob-Peter-to-pay-Paul” principle, with money from new investors used to pay off earlier investors with little or no real investment taking place.
Bernard Madoff’s scheme was similar. Mr. Madoff formed Bernard L Madoff Securities LLC in 1960, and was chairman of the company until early December 2008, when he was charged with investor fraud. He is currently under house arrest in his apartment in Manhattan.

Bernard Madoff set up a very successful securities trading company, initially market making in unlisted equities and subsequently being instrumental in forming the NASDAQ stock market. He was chairman of Nasdaq for a time and his firm’s securities trading widened to encompass NYSE listed stocks as well as Nasdaq. Alongside the securities trading operation, his firm also established an investment management and advisory division. It was in this division that the Ponzi scheme developed.

Mr. Madoff began to attract investors, mainly charities and foundations, and reported competitive and very steady returns. The investment management operation increased in size, especially through the establishment of ‘feeder funds’ that invested all their money with Mr. Madoff. The steady returns combined with Mr. Madoff’s marketing skills attracted more and more funds, allegedly reaching $50bn. Mr. Madoff was repeatedly asked about his investment strategy, and gave broad explanations whilst arguing that the detail was ‘proprietary’. His initial explanations described the strategy as purchasing 30 to 35 blue chip shares from the S&P 100 that were closely correlated to the index, and at the same time selling out-of-the-money calls on the index and buying out-of-the-money puts on the index. The calls increased the rate of return on the portfolio and funded the purchase of the puts, which provided downside protection.

A number of commentators voiced doubts, many were suspicious that Madoff was taking advantage of trading information from the other part of his business by ‘front running’ orders. There were also suspicions that a pioneer of technology like Mr. Madoff continued to give no online access to clients to obtain details of their accounts, and sent all the account statements by mail. In particular, commentators expressed disbelief that Mr. Madoff could produce such improbably stable returns, with so little volatility. Given that the system was so successful, why wasn’t he taking advantage of leverage to increase the returns?

It appears to have been the general fall in the market that finally finished Mr. Madoff. In the words of Warren Buffett ‘it is only when the tide goes out that you get to see who is swimming naked’ and Mr. Madoff was seriously under-dressed. The fall in equity prices saw investors withdraw around $7bn from the investment management operation and Mr. Madoff frantically tried to find more investors. On December 10th he suggested to his sons (who also worked at the family firm) that the firm should pay out several millions of dollars in bonuses ahead of schedule. His sons asked him why and he admitted to the scheme – they then informed the authorities. Mr. Madoff was placed under house arrest and potentially faces up to 20 years in jail, plus a fine of up to $5m. On January 5th 2009, Mr. Madoff mailed jewelery worth up to $1m to his relatives, including his sons and his brother in breach of his bail conditions. Again his sons told the authorities.

Now the chase is on to try to track down the money. Irving Picard is the trustee charged with finding the funds. He has currently recovered around $940m and is thought to be targeting the ‘low hanging fruit’ – the big investors such as the hedge funds that pulled a lot of false profits from the scheme. Federal and New York law enables Mr. Picard to clawback the funds of investors who withdrew either principal or profits in the 90 days leading up to December 11th, the day Mr. Madoff was arrested. Mr. Picard is also potentially able to go back 6 years, particularly if the investors withdrew the money because they had suspicions. The big question remains as to whether funds can be recovered from third party investors who invested in the feeder funds.

Revelations will continue to appear in the press and eventually all will become public knowledge – but the similarities with Charles Ponzi are stunning. Current rumors say that Mr. Madoff did not buy any securities in his investment management operation over the last 13 years and Mr. Madoff certainly lived a very comfortable life while his scheme continued – his apartment in Manhattan, a house in France, a mansion in Florida and a 55 foot fishing boat named ‘Bull’ docked on the French Riviera.