"Ponzi Schemes, Economic Bubbles And Bailouts"

Bernard Madoff, the former Nasdaq chairman who was charged on Thursday with massive fraud, was long considered to be quirky. Employees at the offices of his eponymously named brokerage firm in midtown Manhattan's Lipstick Building had to follow strict rules for what they kept on their desk. Family photos were allowed but only if they were displayed in a simple black frame.

Now it looks like Madoff, who went by Bernie, may also have been a crook, and quite possibly one of the largest Wall Street has even seen. According to the U.S. Attorney's office in the southern district of New York, Madoff admitted to defrauding clients for up to $50 billion in a massive Ponzi scheme that was committed over a number of years.

Madoff was best known for being a pioneer in the business of market-making. His firm, which he started five decades ago with money he earned as a lifeguard in Far Rockaway, Queens, was for a long time primarily in the business of acting as a middle man between buyers and sellers of stocks. It is an essential function for a market like the Nasdaq, which doesn't have an actual trading floor where buyers and sellers can meet face-to-face. Madoff's firm was a major driver behind the growth of the Nasdaq, creating a system that courted brokers who had mostly traded stocks on the larger New York Stock Exchange to do more of their business with the Nasdaq. "He brought a lot of business to the Nasdaq," says Alan Davidson, a former Nasdaq board member and president of brokerage Zeus Securities. "He was a powerhouse on the NASD board. It's a real shock."

While many other boutique brokerage firms sold out to larger firms, Madoff Securities stayed a family business. Madoff for years ran the firm with his brother Peter. More recently, much of the market-making division was headed by Madoff's two sons, Andrew and Mark.

In the 1990s, Madoff used his success as a market maker to help launch an asset-management firm. Madoff raised money for his fund by exploiting his social network, often courting investors at country clubs where he or family members belonged. At the Palm Beach Country Club, Madoff reportedly found a major investor who helped attract other members for Madoff's fund.

Madoff was a donor to the Democratic Party and to Jewish organizations. A number of large Jewish charities are expected to be among the investors who lost money in Madoff's funds. Madoff was chairman of the board of Yeshiva University's Sy Syms School of Business and treasurer for the university's board of trustees. A representative for Yeshiva said the university was still trying to find out if the institution had invested money with Madoff. Also among Madoff's investors was Fred Wilpon, owner of the New York Mets, whose investment firm reportedly had as much as $300 million with Madoff.

"We are shocked at this revelation," said the university representative. "Bernard Madoff has tendered his resignation from all positions and involvement with the university. Our lawyers and accountants are investigating all aspects of his relationship to Yeshiva University."

On the surface, Madoff's funds were supposed to be low-risk investments. His largest fund reported steady returns, usually gaining a percentage point or two a month. The funds' stated strategy was to buy large cap stocks and supplement those investments with related stock-option strategies. The combined investments were supposed to generate stable returns and also cap losses.

But sometime in 2005, according to the SEC suit, Madoff's investment-advisory business morphed into a Ponzi scheme, taking new money from investors to pay off existing clients who wanted to cash out. According to a form filed with the SEC, Madoff reported that the business had $17.1 billion under management in January 2008. As the market got worse this year, Madoff continued to report to investors that his funds were up — as much as 5.6% through the end of November. That would have been a remarkable performance. During the same time, the stocks of the Standard & Poor's 500, where Madoff supposedly did most of his trading, had dropped a weighted average of 37.7%.

Despite his gains, a growing number of investors began asking Madoff for their money back. In the first week of December, according to the SEC suit, Madoff told a senior executive that there had been requests from clients for $7 billion in redemptions. On Wednesday, Madoff met with his two sons to tell them the advisory business was a fraud — "a giant Ponzi scheme," he reportedly told them — and was nearly bankrupt. The sons reportedly contacted their lawyer, who then alerted federal authorities to the fraud. Before being caught, Madoff was working on a scheme to dole out his funds' remaining $300 million to the firm's employees and his family members.

Many who know Madoff say they are surprised by the revelations. "Many of the assets he took were from friends and family," says a former Tremont official. "It is almost inexplicable. Even the people I have talked to who have had long relationships with him are shell-shocked."

A Ponzi scheme is a fraudulent investment operation that involves promising or paying abnormally high returns ("profits") to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It is named after Charles Ponzi. A Ponzi scheme has similarities with a pyramid scheme though the two types of fraud are different.

The eponymous scheme was orchestrated by Charles Ponzi, who went from anonymity to being a well-known Boston millionaire in six months using such a scheme in 1920. Profits were supposed to come from exchanging international postal reply coupons. He promised 50% interest (return) on investments in 45 days or “double your money” in 90 days. About 40,000 people invested about $15 million all together; in the end, only a third of that money was returned to them.

A Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises (and pays) requires an ever-increasing flow of money from investors in order to keep the scheme going.

The system is destined to collapse because there are little or no underlying earnings from the money received by the promoter. However, the scheme is often interrupted by legal authorities before it collapses, because a Ponzi scheme is suspected and/or because the promoter is selling unregistered securities. As more investors become involved, the likelihood of the scheme coming to the attention of authorities increases.

A pyramid scheme is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a disbelief in financial reality, including the hope of an extremely high rate of return. However, several characteristics distinguish pyramid schemes from Ponzi schemes:

• In a Ponzi scheme, the schemer acts as a “hub” for the victims, interacting with all of them directly. In a pyramid scheme, those who recruit additional participants benefit directly (in fact, failure to recruit typically means no investment return).

• A Ponzi scheme claims to rely on some esoteric investment approach, insider connections, etc., and often attracts well-to-do investors; pyramid schemes explicitly claim that new money will be the source of payout for the initial investments.

• A pyramid scheme is bound to collapse a lot faster, simply because of the demand for exponential increases in participants to sustain it. By contrast, Ponzi schemes can survive simply by getting most participants to "reinvest" their money, with a relatively small number of new participants.

  

A bubble. A bubble relies on suspension of belief and an expectation of large profits, but it is not the same as a Ponzi scheme. A bubble involves ever-rising (and unsustainable) prices in an open market (be that shares of a stock, housing prices, the price of tulip bulbs, or anything else). As long as buyers are willing to pay ever-increasing prices, sellers can get out with a profit. And there doesn't need to be a schemer behind a bubble. (In fact, a bubble can arise without any fraud at all - for example, housing prices in a local market that rise sharply but eventually drop sharply because of overbuilding.) Bubbles are often said to be based on "greater fool" theory. Although, according to the Austrian Business Cycle Theory, bubbles are caused by expanding the money supply beyond what genuine capital investment supports, and in this case would qualify as a Ponzi scheme, with expanded credit taking the place of an expanded pool of investors.

   In a weird way I feel sorry for "Bernie" Madoff. After decades of hard work, ingenuity and integrity in the stock market, Mr. Madoff used his good name and reputation to ultimately swindle billions of dollars from his wealthy friends and associates in what is probably the biggest ponzi scheme in history. In my mind, initially Madoff was running a legitimate hedge fund with a legitimate investment strategy that simply failed but instead of accepting failure and loss, he created a ponzi scheme. The problem is ponzi schemes, pyramid schemes and economic bubbles all ultimately collapse and burst. Unfortunately none of the investors in Bernie Madoff's ponzi scheme will be bailed out or get their investment monies back. There is risk in all investments, whether legitimate or illegitimate. Neither greedy Madoff or his bilked greedy investors deserve to be bailed out. In 1999 President Clinton and Senator Phil Gramm deregulated the big commercial banks allowing them to invest in the stock market with the very low interest rates or cheap credit Alan Greenspan and the Fed gave them to create the sub-prime mortgage housing bubble that has collapsed into a US and global recession. As I see it, the Fed and Wall Street created housing bubble is the same as Bernie Moduff's ponzi scheme. Bear-Stearnes, AIG and others should not have been bailed out but rather endured the free market discipline of greedy Moduff and his duped greedy investors. In the free market and Life Itself, we win some, we lose some and we ultimately learn and grow. As I see it, that's a good thing!

tags: bernard madoff  ponzi scheme  economic bubble  wall street bailout  business  capitalism  us  takebackamerica  the economy  

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