Madoff Case Study: The Largest Ponzi Scheme and Stock Fraud

Bernard Madoff ran one of the world's largest Ponzi schemes and attracted thousands of investors offering them a promise of steadily high returns on their investments. He was arrested for securities fraud on December 11, 2008 by the federal authorities.

This article provides a detailed view of his operations and how he was able to get away for so long.

Whistleblower

Harry Markopolos sent damning material about Bernie Madoff in 2000, 2001, 2005, 2007, and in 2008 to the SEC. None of it led to an inquiry of Madoff’s dealings.

Markopolos was working in an investment firm and Madoff’s hedge fund was their competition. Madoff was a highly respected personality on Wall Street and his client list included famous actors, educational institutions and other seasoned investors. Madoff’s unregistered hedge fund was offering massive returns that no one in the market was able to offer.

Markopolos was instructed by his boss to understand and replicate the trading strategy and revenue streams of Madoff’s hedge fund so that they could replicate it in their firm. Markopolos whose training included calculus, algebra and statistics quickly understood that Madoff was peddling a fraud scheme. He used his mathematical modeling techniques to conclusively prove that Madoff’s scheme was a complete fraud.

Red Flags

Outperforming the market for long

Markopolos noticed that Madoff’s hedge fund’s performance line had a distinct upward trend and very few lows. This was unlike the play of other funds whose highs and lows were more equitable. He suspected that Madoff was either indulging in insider trading or he was running a Ponzi scheme of incredible proportions. He started by suspecting fraud in 2000 but by 2005 he had tracked several red flags that proved Madoff was running a Ponzi scheme.

Revenue source unknown

He realized that for Madoff to offer such high returns and the strategy he said he was using in his trades would have to include buying more options than what existed in the Chicago Stock Exchange at that time. Yet on enquiry he found that no one on the exchange was having a trading relationship with him. None of the big trading houses were doing business with Madoff.

Off the charts Sharpe ratio

He also noticed that the Sharpe Ratio was in the range of 2.5 to 4 for 15 years in a row. This was not the case with any other fund and was extremely unusual. Madoff’s name did not feature in any of the marketing literature. It was later found that he often made investors believe that they were the exclusive few who had access to his magic fund.

Zero transparency and promise of exclusivity

Madoff was also known to refuse to share his fund’s strategy and stream of revenue. If anyone asked too many questions he simply said he could not share the details and that the fund was open only to investors who were comfortable with this. Markopolos discovered that Madoff’s split-strike conversion strategy pulled in customers by offering them a fund with blue-chip stocks. The fund seemed fairly diversified. He also said he invested in stock market index put options that would insulate investors against an economic crisis. However, the strategy allowed him to keep making changes at will and was complex enough to flummox sophisticated investors and regulators alike.

What the Market Watchdog Did

The SEC (U.S. Securities and Exchange Commission) took no action despite Harry’s persistent complaint filings. Several people invested their life savings with Madoff and encouraged their friends and family to invest in this too-good-to-be-true investment offer at 12% a year. The returns were so good that no one suspected or asked uncomfortable questions.

How He Did It

Madoff was running an affinity scam according to Markopolos. Madoff was Jewish and leaned on the Jewish community for funds. He then networked to Palm Beach and eventually in Europe as well. These funds gave Madoff billions of their customers’ funds in exchange for high annual fees. These feeder funds did not do the required scrutiny or checks that they were paid by their clients to keep their money safe.

These feeder funds promised to do a thorough analysis before parking funds in different hedge funds. These included risk management, asset verification, stress testing, and portfolio composition. They did none of this because they received high annual fees from Madoff’s company for sending funds his way. The funds now accept that they were in awe of Madoff’s then stellar reputation and did many of the checks they were required to do.

We All Fall Down

Finally, it took bad circumstances for Madoff to turn himself in. He was using new investors money to fund the interest payments of old customers. This meant new funds had to keep coming in. The first setback was the Black Monday crash of 1987, one of the single biggest global stock crashes which led to a low money supply in the market from investors and from which he never recovered.

In 2008, the financial crisis that hit the U.S. had investors scrambling to take out their money. Money that was no longer there and consequently Madoff couldn’t honor these requests. Madoff had been borrowing from European banks and anyone who would forward him money even at exorbitant costs and illegal sources to pay investors. Madoff could no longer roll the money over to pay returns. He could not fulfill client requests and he feared his powerful creditors. Caught in these insurmountable circumstances he confessed to his son who reported him to the Feds who then arrested him.

Investors lost all their hard earned savings and had to sell their remaining assets to survive. Pension pools and trusts got wiped out by investing with Madoff.

The Court Order

The Government order in the United States vs Bernard. L. Madoff case, 2009 made this observation:

In the Government's words, "Madoff's Ponzi scheme was the largest in history." At sentencing, I observed that none of the other financial fraud cases in the district were "comparable . . . in terms of the scope, duration and enormity of the fraud, and the degree of the betrayal." Mr. Madoff's scheme went on for more than 20 years, and the fraud reached "thousands of victims.” The fraud was brazen, as victims were told their monies were being invested in stocks when they were not.

Instead, Mr. Madoff (and others) fabricated millions of pages of account statements purporting to confirm trades that were never made and balances that did not exist. The financial loss was enormous. The loss amount for calculating the Guidelines range was $13 billion, but that amount did not include losses invested through feeder funds, and estimates of the actual loss ranged as high as $65 billion, with some $170 billion flowing through the primary account used for the scheme, ("At the end, Madoff told his clients that he was holding nearly $65 billion in securities on behalf of those clients.

In fact, he had only a small fraction of that amount."). The loss amount of $13 billion was literally "off the chart," as the loss amount chart used to calculate Mr. Madoff's offense level of 52 topped out at $400 million. ("The loss amount of over $13 billion was more than 32 times the baseline level of loss that would have carried a recommended life sentence."). The breach of trust was massive. Mr. Madoff was a respected figure who had held leadership positions in the securities industry. He was on the boards of charities and other organizations. And yet he lied repeatedly to the Securities and Exchange Commission (the "SEC") and created fraudulent certified financial statements to mislead regulators. He lied to governmental entities, charities, academic institutions, labor unions, employee benefit plans, pension funds, large institutional clients, and individuals.

Source

Lessons Learned

Using the wisdom of hindsight, investors can tread forward carefully. There are some steps they can ensure are in place before investing.

  • Expect stable and consistent returns
  • Verify the streams of revenue
  • Make sure the financial advisory uses a third-party custodial firm. They will ensure adequate checks are made and regulations met before allowing funds to be given to other funds. There is a two-tier authentication before your money is invested.
  • Double-check the promise, especially if you are directly investing. If the returns are substantially higher than market returns, this is a red flag.
  • Check for any negative background information and analyze firm filings and audited financial statements.
  • Finally, if a fund promises something too good to be true, then it usually is.
  • Have a diversified portfolio. In the event your high-performing fund fails you will not be completely wiped out.
  • Never be enamored by the fund leader's persona and personality. Always look at the basics of assessing an investment. Due diligence is the best guide to investments.

Cautionary Tale

The Bernie Madoff case proves that despite checking many of these points you could still fall prey to a well-managed Ponzi scheme.

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