Wednesday, January 13, 2010

Madoff's Ponzi Scheme

NEW YORK - JANUARY 5:  Bernard Madoff (C) walk...Image by Getty Images via Daylife
By now everybody have heard of Bernie Madoff, and his Ponzi scheme finally came unglued after decades of deceiving the investors involving at least 50 billion dollars. So how could he have gotten that big? There are three major factors: secrecy, greed, and deception.

A Ponzi scheme is named after Charles Ponzi. The scheme is relatively simple: the people who got out richer was paid by people who got in later. By steadily attracting new people who put their money in, and have more people coming in than going out, the people who get out will get MORE than they put in, and whoever runs this thing can skim off his share as well from the pool. Of course, when people stopped coming in, or just slow down, then the scheme will unravel. There was no real investment and the money is not growing by itself; any growth is from new investors.

Madoff could have kept running that scheme if the depression of 2007-2008 had not caused some investors to pull their money out to cover their losses elsewhere, only to find that there really is no money.

Secrecy is very much a part of Madoff's scheme. He doesn't accept investors directly. Instead, he only takes funds that took other people's money. In other words, he's like the wizard behind all the smoke and mirrors. He also imposed a condition: that no fund that put money with him can list him in any way. His name must NOT appear anywhere. By making this a condition, he can attract MORE funds than people suspect. It also kept him under the radar of the SEC for a long time. It also made him a smaller target, as having less eyes checking him means less chance of exposure.

Greed is the second component of the scheme. Madoff has attracted investments by promising steady growth, 10% to 12%. The funds fed him money because 1) he had a good reputation, even chairman of NASDAQ at a time, and people can't even consider that he may be a fraud, 2) he promised to split fees or even zero fees, which, for a very large fund, mean MILLIONS for the fund managers, for almost ZERO work. The fund managers can keep charging those fees, thus, it all went into the fund manager's pockets. There was no "due diligence" (a "security check" that verifies that their money is invested "wisely"), even though funds are supposed to be very careful with their client's money.

Deception is the third part of the scheme. Madoff have multiple programmers generating fake trades for the statements. And by refusing to do electronic confirmation, but instead, generate fictitious PAPER confirmation statements, it makes auditing the statements very difficult. Madoff was a securities trader, and initially he PAID people to trade with him (paying for volume). And it provides him a cover to do the Ponzi scheme.

Add all three together, and you have people going "it's generate good money, do I really want to know the details?" He even had one of his underlings basically threaten to give back the people's money if they ask too many questions. As it has gotten bigger, the more reputation it has, and the more money it can attract. By combining all three factors, they reinforce each other. People with greed will get taken in by the deception, and the secrecy makes people feel "exclusive", feeling they are the only ones in the deal when in fact they're just a tiny part of it.

In the end, it all must come down, as it is not possible to keep something like that a secret for so long. In fact, SEC had been warned years before, but took virtually no action. In the end, when the economy went south, and people needed to withdraw their money to cover their other losses, the fact that the whole thing is a Ponzi scheme came to light, as no more money is going in and a lot more money is coming out, and there are no funds left.

So what can you learn from the Madoff Affair?

1) Due diligence: do your own homework, don't rely on someone else's advice exclusively. They may be blind to deception or part of the secrecy

2) If it's too good to be true, it probably is. Don't let greed take you for a ride. You'll regret it.

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