Thursday, January 15, 2009

Bernard Madoff meet Charles Ponzi

Earning enough for retirement requires a long term commitment and regular saving. As an alternative, America has a variety of get rich quick schemes, the most famous of which belongs to Charles Ponzi. His scheme dates from 1920 and even though his was not the first, and definitely not the last, he continues to be an American icon for get rich schemes.

Ponzi’s modus operandi called for three separate transactionsin two countries to buy stamps at a low price to resell at a higher price. By international agreement a foreign national could send a letter to an American using their foreign stamp and for the price of a foreign stamp also buy a Postal Reply Coupon to enclose with their mailing. The American receiving the letter could exchange the postal reply coupon for an American stamp to make a return mailing.

Ponzi noticed that he could have a foreign national send him letters with postal reply coupons: the first transaction. Then he could exchange the coupon for an American stamp: the second transaction. Then he could re-sell the American stamp to an American: the third transaction.

He claimed he could earn a 400 percent return, which was technically correct. American stamps were two cents. If you buy a foreign stamp for a half cent and resell it for two cents you have a 400 percent return. However, it is lots of work to earn 1.5 cents. Earning just a dollar requires 66 of the above mentioned three transaction cycles.

Never mind though, Mr. Ponzi formed the Securities Exchange Company and began luring “investors” by selling vouchers for $1,000, which had a written promise to pay investors $1,500 in 90 days.

Beginning in February 1920 investors started buying the vouchers. At first only a few, but the pace picked up in just a few months. As the early vouchers came due Mr. Ponzi made payoffs with the money from new investors.

It was the early payoffs that brought in more investors until by July 1920 reports indicate he had sold hundreds of thousands of dollars in vouchers. The scheme collapsed after 6 or 7 months because continued payoffs require ever increasing investors to keep up.

Money paid was described as income, but payoffs were actually a distribution of other people’s money. In popular lore, any investment that pays early investors from the capital of latter investors is a Ponzi scheme.

This fall’s bad news in the sub-prime mortgage market was a failure of people who were reckless and irresponsible. The current news about Bernard Madoff is worse because his Ponzi scheme, like all Ponzi schemes, requires fraud.

Charles Ponzi’s investors look foolish expecting a 400 percent return from postal coupons. Mr. Madoff had better disguise, but the Securities Exchange Commission was notified of irregularities, which they did investigate. A serious investigation will detect the payout of capital funds. We will hope their failed detection was just incompetence, but Mr. Madoff, gives the strongest message yet this fall that America needs better regulation of financial markets.

2 comments:

Vander said...

As a former fraud investigator with over 25 years of experience in financial fraud, I thought some readers might be interested in my reactions to this story.

The evidence shows Bernie Madoff did not act alone, that key perpetrators include other Madoff family members, that these family members are likely to now control off-shore accounts containing substantial stolen funds.

The Madoff fraud was, without a doubt, a group effort. Bernie Madoff could not have done it all himself. At a minimum he needed three types of support:

1. Computer Systems; unless Bernie hand typed customer statements each and every month, he had computer systems support. Systems support was necessary to track customer accounts, produce false trades, and the myriad of other tasks necessary to create the impression among clients of a real hedge fund.
2. Accounting; two sets of books are more than twice as hard to maintain as a single set. Real accounting systems benefit from automated importing of data from bank and stock trading accounts. In a fraud scheme all this data must be manufactured Off-the-shelf accounting systems send up many red flags when data is not consistent. Fraudulent accounting creates an impression of such consistency where none exists. This is a major task.
3. Tax and Government Reporting: although Madoff went to great lengths to escape government regulation, nonetheless the scheme was bound to standard income and tax reporting requirements. The usual sources for such reporting did not exist—actual income and taxes paid—therefore fake data needed to be manufactured and reported by individuals expert in these isssues.

Therefore, it is certain Bernie Madoff did not act alone and, at a minimum, had knowledgeable coconspirators in computer systems, accounting and tax and government reporting. It is highly likely that the conspiracy involved a much larger group.

It is also highly likely that fraud scheme was a family enterprise. Like the Mafia, the family is the basic unit of most organized fraud schemes. The reason is simple—outsiders create a substantial risk of defection or blackmail. There is no honor among thieves. Bernie Madoff’s business was a family enterprise family members heading up all major functions including, computer systems, accounting and tax and government reporting.

In his warning to the SEC Harry Markopolos listed 29 red flags that the Madoff hedge fund was a Ponzi scheme. All of these flags were visible to family members working in the firm every day. They had to have known a great deal more including the fact that all the trades Bernie Madoff claimed to be making never occurred. Close-up views of every fraud scheme I have ever investigated made it clear the emperor has no clothes. The most that can plausibly be claimed is that family members knew what was happening and did nothing.

Bernie’s story is that at the last minute he informed his wife, his brother, and his sons that all was not well and that acting alone he had for seventeen years perpetrated the largest Ponzi scheme in history. Being shocked, shocked that fraud was going on the sons went to the authorities the very next day. None of this is in anyway believable. That the sons participated in this charade is evidence of long-term involvement

Third it is likely that a significant portion of the lost billions are in hidden accounts or bonds controlled by family members. Money laundering is not difficult given time and financial sophistication. The Madoff scheme had a great deal of both.

All Ponzi schemes come to an end sooner or later. Therefore, the perpetrators inevitably develop exist strategies. I cannot believe the Madoff perpetrators did not do the same. New alternative identities are almost as easy to create as money is to launder.

Given these facts, I suspect that prosecutors will concentrate Madoff family members as the most promising method of recovering stolen funds. Without perpetrator cooperation laundered funds are seldom found. Bernie Madoff will be spending the rest of his life in jail, therefore there is no plea bargain possible to gain cooperation. The fate of other family members creates much greater leverage. In return of full recovery and accounting of all Madoff Ponzi scheme funds, the prosecutors are likely to trade leniency for some family members.

In the absence of such a full accounting and recovery I predict that, in a few years, when things a quieted down, one or more Madoff family members will quietly disappear and then a new mega-yacht will appear in St Moritz owned by an Americans with a vague backgrounds.

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