Feature

Issue of the week: The Ponzi scheme that’s shaking Wall Street

In what may be the largest investment scam in history, Bernard Madoff was charged last week with securities fraud after confessing to running a $50 billion “Ponzi scheme.”

How did Bernard Madoff get away with it for so long? asked Binyamin Applebaum and David Hilzenrath in The Washington Post. In what investigators say may be the largest investment scam in history, the head of Bernard L. Madoff Investment Securities was charged last week with securities fraud after reportedly confessing to running a $50 billion “Ponzi scheme” that snared celebrities, wealthy retirees, and several charities. Investigators haven’t said when Madoff began “the fraudulent practice of using new investments to pay existing investors”—the definition of a classic Ponzi scheme. But he appears to have somehow escaped detection by perfecting the art of “misdirection.” While he was luring investors into his hedge fund with promises of low-risk, above-average returns, authorities said, “he simultaneously operated a legitimate, regulated, and high-profile business as one of the largest middlemen between buyers and sellers of stock.” Regulators focused on that so-called market-making business and paid little attention to Madoff’s money-management activities.

The Securities and Exchange Commission has some serious explaining to do, said Tom Lauricella in The Wall Street Journal.  It’s now clear that for years the agency ignored evidence that something was terribly wrong with Madoff’s operation. Some market insiders have long maintained that Madoff’s purported investment strategy couldn’t possibly generate the steady returns he was delivering. Madoff claimed to earn high returns by buying stocks and simultaneously trading options on those stocks, profiting on tiny price differences between the two. (An option is the right, but not the obligation, to buy or sell a given stock at a specific price on a specific date.) But to do so, he would have had to trade far more options contracts than actually change hands daily on the nation’s options exchanges. Such discrepancies convinced Harry Markopolos, a rival money manager, that “the results likely weren’t real.” He wrote to the SEC back in 1999 warning that “Madoff Securities is the world’s largest Ponzi scheme.” The SEC has now launched an internal investigation to determine why it ignored such warnings.

Whatever the SEC finds will come too late for Madoff’s vanquished investors, said Kathy McCabe in The Boston Globe. Madoff enlisted many friends and family members to invest in his fund, including his sons Mark and Andrew, who also worked for their father. Last week, Madoff confessed the scam to them, and they alerted the authorities. Other victims include film producer Steven Spielberg and real estate mogul Mortimer Zuckerman, as well as Jewish charities such as Boston’s Robert I. Lappin Charitable Foundation, which lost its entire $8 million endowment. “We have no money,” said Executive Director Deborah Coltin. “We can’t continue.”

What may be as disturbing is that some people who invested with Madoff did so because they thought he was a crook, said Henry Blodget in BloggingStocks.com. “The smart money knew he had to be cheating, because the returns he was generating were impossibly good.” It would appear that these investors “assumed Madoff was somehow illegally trading on information from his market-making business.” They were happy to profit from what they thought was an insider-trading scheme, never imagining that Madoff was instead “running a good old-fashioned Ponzi scheme.” Now they know.

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