Fenil's Library

When Ponzi lost his scheme to Madoff

In scale as well as reach, the latest Wall St fraud is the biggest ever

 Vivek Kaul. Bangalore

“The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolise men who are making a lot of money, and assume that they know what they’re doing” —Paul Krugman, Nobel Prize-winning economist

As the flight took off from the Bangalore airport, I was looking to an hour and half of a peaceful snooze. But I hadn’t taken into account the fact that she was sitting next to me.

“What is a Ponzi scheme?” she asked.

“Why this sudden interest?”

“Well, Bernard Madoff, a highly respected figure on Wall Street until recently, has admitted that the investment fund he was running was essentially one huge Ponzi scheme. In fact regulators are now saying this may be the biggest Ponzi scheme the world has ever seen, at around $50 billion,” she said.

“Hmmm... Ponzi scheme gets its name from Charles Ponzi, an Italian immigrant to the United States of America, who promised investors in 1919 that he would double their money in 90 days, which he later reduced to 45 days. Money started pouring in as no other investment in the market at that point of time offered such high returns. At its peak, the scheme had 40,000 investors who had invested around $15 million in it. Ponzi thought he had in place a business model that could help him deliver the astonishing returns he had promised. But all he ended up doing was use he money brought in by new investors to pay off the old investors.”

“So, basically no new wealth is created in a Ponzi scheme. But, wouldn’t such a scheme last only as long as the money entering the scheme is more than the money leaving the scheme?”

“You are right. This was the case with Madoff’s investment fund. In the beginning, he tapped money locally. He targeted country clubs, Jewish charities (he was a Jew himself) and even charity dinners. He was good at networking, of course. As his fame grew, on the back of consistent returns of 10% per year that his investment fund generated, other feeder funds started to invest money into his investment fund. Madoff’s fund continued to do well even when the broader market was falling. Even as recently as November, when the US market fell by 7.5%, this fund generated positive returns. All this good news led to the fund bloating even more, and when this happened, he needed even more new investors who would invest money to be able to pay investors who wanted to redeem their investment.”

“So what did he do?”

“Well, he started to look at markets outside the United States. His salesmen touched base with investors in Europe, the Persian Gulf, South East Asia and finally China. This is the first true blue global Ponzi scheme.,” I explained.

“I don’t get one thing. Madoff ran this fund for years. How come no one questioned his investment strategy?”

“Good question. In a Ponzi scheme, the investment strategy followed appears to be a genuine one, but at the same time it is obscure enough to prevent any scrutiny. Madoff, when asked, told his investors and other investing professionals that he was employing a strategy known as “split-strike conversion.” This is a common investment strategy employed by derivative traders and investors. Other fund managers who had tried it were of the view that it was impossible to generate the kind of returns Madoff was generating using this strategy. However, no one really questioned it because Madoff’s fund kept generating the so-called consistent returns. This consistency also ensured that the investors rolled over profits into the next investment cycle. This is another characteristic responsible for the success of Ponzi schemes — as more and more people roll over their “profits” by not redeeming their initial investment, the chances of the scheme surviving increase. In Madoff’s case, the “so-called consistent returns” assured investors that their investment is safe.”

“But if everything was going so well, why did the fund collapse?” she asked.

“Well, October and November have been particularly bad months for stock markets worldwide. Due to this, a lot of investors wanted to redeem the money they had invested. At the same time, new money wasn’t really coming in. In early December, Madoff was struggling to raise nearly $7 billion to redeem the money his investors wanted back. A little later, on December 10, he called his sons and his employees and admitted that there really wasn’t any investment model in place and that his fund was one big Ponzi scheme. What broke Madoff’s back was essentially the same thing that has broken the back of every Ponzi operator before him — the point where the money leaving the scheme exceeds the money entering it.”

“How come nobody figured this out?”

“Typically, people running a Ponzi scheme have a ‘halo’ around them. Indeed, many cases of financial fraud involve individuals with charming and convincing personalities who have an ‘infectious optimism’ that makes others trust them. Madoff, for example, was a family man who did a lot of philanthropy as well. He was also the non-executive chairman of the Nasdaq stock exchange for a few years in the early nineties. All this worked for him.”

“Will the number of Ponzi schemes come down in the days to come?”

“I don’t think so. Over the years, investors have been fooled into investing money into various Ponzi schemes. They ignore the most fundamental principle of investment theory: You cannot make large profits without taking risk. Investors should logically seek large amounts of information before investing. But most do not do so. Few ask the right questions at the right time and are naive enough to believe in what is communicated to them by those carrying out the fraud. Most are driven to investing in such schemes by greed.

“Maybe we should start calling Ponzi schemes as Madoff schemes now.”

“Oh the renaming has already happened, at least in the US press.”

(The example is hypothetical)

k_vivek@dnaindia.net

References: ‘The Madoff affair: Con of the century’, The Economist, December 20, 2008;Madoff scheme kept rippling across borders,The New York Times, December 19, 2008