This Is the End


Markets, Risk and Human Interaction

January 2, 2009

Reflections on Madoff

The Madoff Ponzi scheme will (I hope) be the high watermark for financial fraud for many decades to come. It is hard to overstate the harm it has done, with lifesavings and fortunes lost, charities and schools left foundering.

“It fell off a Truck”
Did his investors really believe Madoff was doing split-strike conversions? Given that there were not enough options in the world for Madoff to do such a strategy? And given that no one in the industry heard of him as a player in that market?

An alternative view is that the split-strike conversion story is the equivalent of the “it fell off the truck” story for people buying stolen goods; that investors suspected he was involved in illegal front running, and would just as soon not have had that spelled out for them while the money kept flowing in.

It’s the same old story, just bigger – and smaller
Bigger because people have more money. Bigger because it is easier to create links and indirect “circles of trust” by using banks and other feeder funds as agents. Bigger because it was bigger: people implicitly trusted the regulators to do their job, and thought that surely nothing could be fraudulent if it was this large and well known.

But part of his genius was that in one respect his scheme also was smaller. He did not make the classic confidence artist’s play on avarice. The good, old fashioned Ponzi schemes are of the get-rich-quick, double your money in three months variety. Madoff’s was conservative, offering lower expected returns than many other investment opportunities.

Putting all your eggs in one basket

Madoff could get away with modest but steady returns because with credit so abundant his investors could use leverage to push the returns up. My guess is that in many cases the people who were wiped out did not have their entire portfolio in just this one fund, but rather borrowed money to create a levered position. If you can make 10% almost for certain, why not lever four times and get 40% return with a little more volatility? Because of that leverage, the fund’s failure engulfed their other investments.

We are shocked, shocked
The day after the story broke, I wondered why Madoff didn’t just grab $30 million and skip town. The likely answer is that then his kids would have been left holding the bag. I would have loved to hear the conversations between him and his sons the night they heard the gig was up, and decided they would have to turn him in.

How could anyone so close to the scheme, and in the market making business to boot, not see any of the red flags that Harry Markopolos was waving in front of the SEC for the past ten years? I wonder if they had all of their money in their Dad’s fund?

Is there a managed account in your future?
A lot of investors are going to be asking, “So remind me again what the problem is with putting me in a managed account?’ Why can’t a hedge fund operate by doing trades pari passu across various client accounts – especially if the fund is in liquid markets? With a managed account the investors then have control over their money, so it is a lot harder to do any sort of monkey business.

The usual argument is the risk of transparency. In most hedge funds, I don’t buy it – especially if transactions are available for view only with a delay. In any case, my bet is that we will see more demand for managed accounts down the road.

Are we all a Ponzi scheme?
I suppose it is irresistible. If you are a columnist who has to find something to write about three times a week, latch onto the Madoff story with a metaphor to the growth of leverage by banks and individuals. Even intellectual luminaries like Paul Krugman and Thomas Friedman have gotten into the act.

But I don’t see the connection. With Madoff you have someone who is committing fraud. With leveraged investing you have people making investment decisions. Those decisions might not have been the right ones ex post, but a Ponzi scheme?

There is plenty to think about without straining that hard. Still, I don’t think we’ve heard the last of this.


  1. OnlyOneLosingDayLastYearJanuary 3, 2009 at 6:02 AM

    I'm still struck by the story (darned if I can find the link) of the two guys in Florida who were busted by the SEC for selling unregistered securities. They were feeding the money to Madoff. This was in the '70's. Madoff's name was redacted from any and all SEC documentation because he convinced them he "had no idea they were raising the money illegally", he was just trading the funds they sent him. Funny thing, to their surprise, when the SEC looked, they found all the money, it hadn't been stolen. Personally, I think decimalization did Madoff in, ruining his money-printing Nasdaq market making capabilities.

  2. Just think Wang Zhendong!

  3. On some level the investors absolutely felt that there was something illegal, but they cannot and will not admit that to themselves now or ever.

    Are we all a Ponzi sceme???? Our global housing market could be the grand-daddy of all Ponzi schemes...from Miami to Greenwich to the Bahamas to Dubai. I am telling you, here in Pennsylvania, people still have their houses marked at 2005 prices in their minds. We have not started to see the house next door sell at 03', 02' 01' prices, or the unimaginable....Y2K prices! Although, the dumpsters have disappeared from all the driveways.

  4. Mr. Madoff’s alleged $50 billion dollar Ponzi scheme lasting for 20-30 years, makes Bernie a big time con man but not a genius, as so many have intoned. Mr. Madoff simply understands human nature, we all want something for nothing and if we feel we are the chosen ones, so much the better. If Bernie can convince America that he was insane during his decades-long financial swindle, I will then consider him a genius and the aggrieved marks, too stupid for words.

  5. here is one example of a ponzi scheme run by most investment banks out there. you enter a structured swap or some other complex structure that your model values at say 100. some arranger sells it to you for "only" 90. you instantly have a profit of 10. of course, you need some reserve against it to keep auditors happy, so you reserve 2, which still leaves you 8. you have complex math to back each of these numbers, but your complex math relies on very weak assumptions on things like correlations and volatilities, but you make up for it making the math even more complex. the more such structures you enter, the more PL, so you and everybody else go for it and write tons of them over the years. the traders and salesmen get themselves promoted and receive million dollar bonuses. share prices go up, happy days. and now the ponzi part. that product is often long term. you need to delta hedge for years that model value that gives you your PL, often in illiquid markets. you and everybody else doing this business start chasing the same hedge at the same time, which makes you lose money steadily over the time. but this is not a problem, you can write more PL by buying at 90 and valuing at 100, easy. and you see where this is going. in case you are wondering why banks have enormous tier 3 asset positions, this is part of the reason. they got taken on because it was an easy way to show profit. so yes, I think there are many ponzi schemes out there, more subtle than madoff though, and interestingly enough, it is all legal under current laws and accounting standards.

  6. Fractional-reserve lending is the largest Ponzi scheme in history, and we're all part of it.

  7. While some of the participants surely had an inkling that all was not right about the way Madoff earned the money on their investments, there are many who would not have had a clue. The average investor, who could be counted among the investors in Madoff's fund, would not have the slightest idea about the size of the option market and what is reasonable. Nevertheless, there are no doubt some who probably shared backroom laughs with Madoff about his ability to frontrun the market.

  8. What floors me, is that a basic understanding of options theory should have raised alarms when considering his strategy. This wasn't a $100 million scheme. This was $50 billion. The strategy was completely, impossible. I figured out is was impossible in 10 seconds before the Markopolos letter was known and not because I am super smart. A simple understanding of options theory was all that was necessary to tell you those returns are absurd. Which means he needed other skills. But if you have other skills, there's no way they're going to be that absolutely consistent. The fact that the SEC couldn't see anything, or didn't even try, the fact that his brother in law was the auditor, that FOF due-dilligence never fundamentally questioned the strategies or else believed he was *illegally* front running his customers to the *benefit of them* (which I'm sure has a lot of truth to it, but I have to marvel at how absurd that belief is now that I reread it, who'd they think he was, Robin Hood?). And they believed these things enough to put billions upon billions of dollars with him. I think it's comically absurd to suggest that such people would be in the control of such large sums of money to invest. Of course it's not comical at all.


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