It was December 10, 2008, and Wall Street was running as it normally does every day; telephones ringing, brokers doing their best to work their magic, the overlapping sounds of keyboards, staplers and binders making the ruckus it always does. Everything was perfectly normal, until the telegram popped up with the message that cost over 4800 clients a combined loss of at least $65 billion. “Bernard L. Madoff Investment Securities LLC has been a scam. The whole thing was a lie.”
This catastrophe had been the work of one man, Bernie Madoff. He had just been caught for pulling off one of the biggest financial scams the world had ever seen.
Madoff had been running a Ponzi scheme, a fraudulent investing scam promising high rates of returns with little risk to the investors. This is similar to a pyramid scheme, generating returns for early investors by acquiring new investors. In both cases the income generated by the new investors is used to pay off the original investors’ returns. While Pyramid scheme partcipants are aware that they earn by recruiting, the returns of Ponzi scheme participants are falsely marked as profits from legitimate transactions.
The Ponzi scheme is named after the swindler who orchestrated the first one in 1919, Charles Ponzi. He used the constant fluctuations of postage prices, which made stamps more expensive in one country than another. Ponzi hired agents to purchase cheap international reply coupons in other countries and send it to him. These were exchanged for stamps that were sold at a profit. This type of exchange, known as arbitrage, is not an illegal practice. But Ponzi became greedy and expanded his efforts. Under the heading of his company, Securities Exchange Company, he promised returns of 50% in 45 days and 100% in 90 days. Due to his success in the postage stamp scheme, investors were instantly attracted. But instead of actually investing the money, he just redistributed it and told the investors that they made a profit.
Regardless of the technology used in the Ponzi scheme, most share characteristics such as:
- A guaranteed promise of high returns with little risk.
- Consistent flow of returns regardless of market conditions.
- Investments that have not been registered with the securities and exchange commission (SEC).
- Investment strategies that are secret or described as too complex to explain.
- Clients not allowed to view official paperwork for their investment.
- Clients facing difficulties removing their money.
Madoff’s asset freeze created a chain reaction throughout the world’s business and philanthropic community, forcing many organizations to close at least temporarily. Big names like Steven Spielberg and Kevin Bacon were also involved. This happened because at least $35 billion of the money Madoff claimed to have stolen never really existed, but was simply fictional profits he reported to his clients. Actual losses are extremely difficult to calculate since the amounts that investors thought they had, were never attainable in the first place.
General Ponzi schemes, if not stopped by the authorities, usually falls apart for one of the following reasons:
- The operator vanishes, taking all the remaining investment money.
- Since the scheme requires a continual stream of investments to fund higher returns, if the number of new investors slows down, the scheme collapses as the operator can no longer pay the promised returns (the higher the returns, the greater the risk of the scheme collapsing) Such liquidity crises often trigger panics, as more people start asking for their money.
- External market forces, such as the sharp decline in the economy cause many investors to withdraw part, or all of their funds. This is what happened in the Madoff scandal, when many market investors asked for their money back during the market downturn of 2008. As the market’s decline accelerated, investors tried to withdraw $7 billion from the firm. Unknown to them, Madoff had simply deposited his client’s money into his business account, and paid customers out of that account when they requested withdrawals.
Often, high returns encourage investors to leave their money in the scheme, so the operator does not actually have to pay the investors frequently. He simply sends statements showing how much they have earned, which maintains the deception that the scheme is an investment which earns high returns.
So while making an investment, if the returns sound too good to be true, they probably are. The Ponzi scheme has come a long way since then and is related to crypto currency even today. Bernie Madoff will, however, go down in history for all the havoc he created using one simple lie. Despite how sly he was, we can’t help but admire the brilliance behind his story, making him the real wolf of Wall Street, and one of its best con artists.
– Arjun Suresh