The Bernie Madoff Ponzi scheme is undoubtedly one of the best known fraudulent transaction still date.
What made this scheme so noteworthy is the sheer extent of money it generated and the man it is associated with, Bernie Madoff.
A former stockbroker, investment advisor and one of the founders of the NASDAQ stock exchange, he was hardly the person who you would expect to run an illegal scheme.
Perhaps that was also the reason that he knew how to hoodwink the system best.
Such was the planning that the scam went unnoticed and even the SEC could not spot it till Madoff pleaded guilty.
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The Bernie Madoff Ponzi Scheme
Bernie Madoff was finally caught in December 2008 and sentenced to 150 years of imprisonment.
He was charged with more than 10 counts of money laundering, perjury, theft and fraud for conning over $65 billion.
So what exactly was the nature of the Ponzi scheme and how did they swindle money?
As we mentioned, Madoff was an extremely well-respected financier and convincing his investors was not difficult at all.
Madoff succeeded in convincing thousands of investors to handover their savings, and in return, he promised stable and continuous returns.
The fact that Madoff knew the system so well and the rate of return was not astoundingly high ensured that he could play the game stealthily for decades before it got exposed finally.
The Ponzi Scheme Key Person
Predominantly, if you would notice that this type of Ponzi schemes almost always has a key person.
This person invariably is the one who creates the scheme, shuffling the money around, paying returns to the older investors and collecting funds from the new joiners.
This is what keeps the scheme running and appear legitimate to most investors who are putting in their money, though no profit is really being generated by the business.
Bernie Madoff meanwhile continued to skim the extra cash collected as profit and kept expanding the business gradually.
Another interesting aspect of this Ponzi Scheme like many others is that it encouraged its investors to roll over investment and earn further returns.
This inevitably solved the problem of too many investors claiming money all at one go.
The investment strategy was kept a top secret, and no one really was privy to it apart from the actual perpetrators.
Only when the inflow of fund dwindles, the scheme begins to flounder, and the same thing happened with the Bernie Madoff Ponzi scheme.
In this case, matters really came to head when customers demanded close to $7 billion in claims.
Madoff, at that point, had less than $300 million left to pay off his investors.
How Madoff’s Scheme Avoided Scrutiny?
Whenever the Bernie Madoff case is discussed, one issue that always pops up is how he avoided SEC scrutiny and any kind of investor suspicion till the time Madoff himself went and pleaded guilty about the Ponzi scheme he started?
Well, a cardinal factor is no doubt the person that he was.
- He was a well known investment advisor
- He spearheaded the launch of Nasdaq Exchange
- He had a perfectly legal and respectable trading related firm since 1960
- He was on the National Association of Securities Dealers Board
- He even held an advisory role in Securities and Exchange Commission on myriad trading issues
So how could this market veteran lead you to something that is illegal or against investors interest?
The result was the massive $65 billion fraud, and most of his investors are still reeling under the severe impact of this nightmare.
For most, they have not yet been able to recover the investment they made, forget about the returns expected.
The Three Primary Factors
So overall when you analyze the entire Bernie Madoff Ponzi scheme, there are some extremely striking features about this Ponzi scheme that enabled it to thrive successfully for such a long time.
Of course like we mentioned Madoff’s personal equations were no doubt there but that apart, there are some other important links to the entire game plan as well.
1. The Investment Strategy
We all know that most successful Ponzi schemes have rather secretive strategies that are not commonly discussed.
Well, this one was no different.
He bought well known blue chip stocks and then went ahead to take option contract in these.
On an average, a position like this would comprise of owning 30-35 S&P 100 stocks which are correlated to the index, sell calls on the index and this is what leads to increase in returns.
The ‘puts’ in this case is funded by the sales and oft talked about Madoff approach limit the portfolio’s downside.
The 5% payout rule was also aided the Bernie Madoff Ponzi scheme in an important way.
The US law required all private foundations to pay 5% of the total funds every year.
This meant that for every $1 billion investment that Bernie Madoff did in foundations, he was allowed to withdraw $50 million a year without question.
Therefore by targeting various charities, Madoff easily avoided any probe in sudden withdrawals.
Another interesting aspect, in this case, was the fact that Madoff, unlike other Ponzi schemes actually had a real brokerage business acting as a front to deceive investors.
2. Sales Strategy
Bernie Madoff knew unusually high returns would easily raise eyebrows and unnecessary attention to his business.
He used a simple tactic to sell his Ponzi scheme to investors.
He offered a modest but ”steady’ rate of returns irrespective of market conditions.
That coupled with the complicated investment strategy and secretive business fundamentals ensured that most investors who invested did more on the basis of the faith they had in him.
Madoff additionally created an element of exclusivity about the fund.
As a result, his investment Ponzi scheme got an aura of the best and increased the allure for it further.
This ensured that most whom got to know, ensured they invested and continued for the longer term.
The unusually consistent returns soon became the key factor, and by keeping it at a modest 10%, Madoff managed to continue this game for thus far.
3. The Elite Access
The other important factor that helped a big deal was no doubt the kind of access that Bernie Madoff had to lawmakers and the contact that his family cultivated in the Washington circles.
The high level ties, the big chairs that he and his family members occupied is often attributed as a key factor that led to the success of the Ponzi scheme he created.
All in all, the Bernie Madoff Ponzi scheme is a story of deceit, opportunity and shrewd business sense.
Perhaps, the relatively long duration that it continued for made it worse and increased the extent of damage that it caused.
While his 150 years imprisonment is symbolic, it is hoped that the sheer severity of the punishment would deter future Ponzi schemes of this stature.
The point is sometimes the nature of an investment company pushes it to act as a Ponzi scheme in long-term.
Maybe many of the Ponzi schemes didn’t want to be “Ponzi” at the beginning, but the conditions caused them to follow a Ponzi system at least for a while.
However, it became impossible for them to get out of the trap they had created on their own.
Many of the market maker brokers have to follow a Ponzi system when the number of their profitable traders and investors goes up.
Having no proper investment plan as well as the bad markets conditions cause the brokerage companies like Madoff’s to become obliged to work as Ponzi scheme.
Although the solution is easy, but the owners avoid it because they don’t want to ruin their credit.
They can easily stop the business and return everybody’s money right when they see they are losing more than what they have to make.
Encouraging people to invest and considering a fixed amount of monthly or yearly return, even very low, is the most stupid business one can run, especially when the returns have to be dependent on the investment and trading in the currency and stock markets.
The reason is clear:
You can’t make a fixed amount of profit every month/year because (1) the markets’ conditions don’t allow you to, and (2) you can’t work properly with the others’ funds while you have to return a fixed amount of profit.
That was also the case with Bernie Madoff and his Ponzi scheme.
If you buy the Bank of America’s stock for example, they won’t have to return any interest every month or year.
You invest at your own risk and if the stock’s value goes up, you will make some profit.
You will lose money if it goes down.
This is a healthy investment that the company, the Bank of America in this case, doesn’t have to pay you any interest.
However, when you invest your money with an investment company who promises a fixed amount of monthly or yearly return, you are playing with fire, because there is a big chance that the company already is or becomes a Ponzi scheme like the Madoff’s.
It is true that Ponzi schemes like Madoff are illegal, but those who lose their money in such schemes, lose it to their own greed.
Keep in mind that any company, scheme or program that promises a fixed amount of return, either is already a scam or will become a scam sooner than later, simply because there is no investment strategy and market that can constantly return the profit that these companies promise to pay to their clients.
When you invest with a company that returns 10%, like what Madoff was used to, you should know that you are losing your money to your own greed.