The Madoff Scandal
Written by Sushovan Rudra, IIM Indore (batch of 2011) Monday, 10 August 2009 00:00
On 11 December 2008, a tsunami hit the already neck-deep-in-trouble world of finance. That day, the high-flying Bernard L. (Bernie) Madoff, former NASDAQ chairman and founder and primary owner of Bernard L. Madoff Investment Securities LLC, was arrested by US federal agents and charged with running a colossal $50 billion Ponzi scheme.
Let me briefly illustrate how a Ponzi scheme functions. Vito Corleone, a sinister swindler, offers Mario a 25% return on a six-month contract. This is an offer Mario cannot refuse, so he goes ahead and invests Rs 1000. After six months, Vito has to pay back Rs. 1250 to Mario. From where would Vito get the additional Rs. 250 ? He accosts Francis and offers a 25% return on a three-month contract. Impressed, Francis invests Rs 2000. From this amount, Vito pays Mario Rs 250 and keeps the rest. After three months, Vito has to pay Francis Rs 2500 but he has only Rs 1750 with him. So the ingenious Vito lures Marlon to invest in his contract. Subsequently, word had gone around about Vito and his investment schemes which are simultaneously high-yield, low-risk and short-term. Al and Robert decide to invest and turn up in Vito’s office. Vito always has enough money to pay back investors because more and more investments are coming in. As news spreads far and wide, an increasing number of investors are feeling left out and itching to jump in. This is a result of ensuring either abnormally high or unusually consistent return-on-investment. Note that Vito is not making any profit. He has adopted the ‘rob-Peter-to-pay-Paul’ principle by roping in new investors to pay the returns. He has successfully created a ‘bubble’.
In between, Mario, Francis and Marlon are so impressed by the high return-on-investment and the liquidity of the scheme that they decide to reinvest their entire amounts (principal + interest earned). This ensures that Mario doesn’t have to ‘pay’ the early investors. He prepares a few fake certificates where he enumerates how the investors’ money is growing. This is enough to deceive the investors, most of whom don’t have in-depth financial expertise. However, investors who want to withdraw money are promptly serviced, thereby providing credibility to the fraudulent scheme.
Bernie Madoff’s modus operandi, although much more complex, was based on the above described scheme. In addition, he worked diligently to project a nebulous and enigmatic image of himself. He meticulously and secretively devised his version of the Ponzi scheme. He didn’t let anyone access important documents. He refused several clients to create an aura of exclusivity for his existing clients. His clients forgot that investment is all about strategy. They committed the fatal error of putting blind faith in Madoff. His client list included high-profile names like John Malkovich, Larry King and Senator Frank Lautenberg. Life savings of retirees, single mothers and small investors weren’t spared. He conned numerous charitable institutions too.
Bernie developed rapport with a few Washington lawmakers. Apart from serving as chairman of NASDAQ, Bernie was a member of the board of directors of the Securities Industry Association. That probably explains how he managed to thwart the law for so many years. The financial crisis, however, nailed him. Investors started withdrawing funds. Simultaneously, no new funds were forthcoming. When the choking of funds happened, the ‘rob-Peter-to-pay-Paul’ principle ceased to work. The Ponzi scheme collapsed like a pack of cards.
Madoff remarked in court that his misdeed was “An error in judgement.” Probably the thrill of deceiving people was too hard for him to resist. On 29 June 2009 the contrite septuagenarian was sentenced to 150 years in prison.
Refernces
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