The biggest non-news item to break last week was this Bernie Madoff fellow and his billion dollar Ponzi Scheme. I say it’s non-news because the people that lost money here are admitting they didn’t really know how the guy was able to consistently make money. If you invest in something you don’t understand, and it’s too good to be true, it probably is. While this guy is a criminal that has ruined lives, the burned clients should have been more prudent.
But let’s not get ahead of ourselves. First of all, what is a Ponzi Scheme. It is not a pyramid scheme, so don’t listen to Faux News or that Coyoti guy in CNN’s Situation Room tell your otherwise. A Ponzi Scheme is, by design, destined to fail at some point. One can only be left to assume that the designer hopes to disapear with a profit, die before being discovered, or manage to close down a “successful” business without anyone noticing. The fraud is named after Charles Ponzi, who ran not the first, but one of the biggest such schemes back in the early 1900s. Ponzi initially started a legitimate business to make money in currency exchanges with coupon stamps, but as the business took off he started paying investor returns with money being brought in from new investors. For a Ponzi Scheme to be truly successful, the old investors must largely choose to reinvest their earnings. This isn’t really all that difficult because every investor will be happy to reinvest their earnings At a certain point, one crosses a threshold where the income statements to investors are simply made up and there is no real money backing the numbers. The scheme might manage “billions” but only has to pay out a few million each year for the people not reinvesting. This is easily funded by the money from new investors. The Boston Post and the guy that started Barron’s eventually busted him. Without giving you a full write-up, in order for the business to actually work as it was, 160 million coupon stamps had to be in circulation. Only about 27,000 were.
Bernie Mad’s scheme was also built around duping investors. Bernie had started and owned an investment house since the 1960s. It later morphed into a hedge fund style company with it’s own brokerage house. It is rare that a hedge fund does it’s own brokerage operations. Doing so effectively shields you from having to report any transactions to the SEC. By promising large returns, and giving them, Bernie Mad was able to continually bring in new clients that wanted the returns he was offering. Once he attained “investment guru” status, a hypothetical rank reserved for the like of Warren Buffet, no one would question the wonderful returns he was able to consistently give investors, despite various down markets.
Reports of Madoff’s Ponzi Scheme date back to the 90s but they never moved passed “rumor” status. We have this recession to thank for outing Madoff. With money tight, even in wealthy circles, new customers were hard to come by. Existing customers were also pulling out money, as is the case everywhere. But this didn’t cause Madoff to go under. Nope. Finally though, people became very suspicious of Madoff’s consistent returns, despite a recession. Because Madoff ran his own brokerage house and structured the company like a hedge fund, he was free of regulatory filings. Madoff was one of the founding members of the NASDAQ and served as president for a time. The NASDAQ is an all electronic exchange. Being on the for-front of technology, it was surprising that Madoff never distributed anything to client electronically. It was all snail mail. This made it easier to conceal the fact that everything was made up.
Last week, Madoff was arrested by the FBI after a joint investigation with the SEC. He basically threw up his hands and said “Yep it’s a Ponzi Scheme, I’m done”.
Some have said that the SEC may have known about this for years and did nothing. That’s like saying the EPA knows you’re stealing from work. The EPA can’t do anything. The SEC doesn’t have the power to regulate hedge funds. Many people have been calling for such regulation for years, maybe this will kick-start some legislation.
Click here for a growing list of people affected by this awful greedy jerk. The list includes non-profits and charities. This guy will burn.
Now put all that aside. I want to talk about where this $50 billion in losses came from. $50 billion is essentially a fabrication. The money never really existed. If you worked with Madoff for a decade, then all the money you’d invested was already gone. Because of all the fudged numbers, there is no way to quantify actually how much money was lost. If you invested $1 million 10 years ago and Madoff told you it was now worth $20 million, you actually only lost $1 million. The $50 billion loss is the on paper losses that resulted from the fraud. The media would serve us better to clarify such things. Instead you’re left imagining $50 billion in cash being set on fire, which is of course the picture the media would like to paint anyway.
The lesson: Invest only in things you understand. This guy won the confidence of his investors, which allowed him to avoid explaining how he was making money. Always in a Ponzi Scheme, you can imagin putting your money in a box, walking away, and coming back later and there is more money in the box.
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
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