In just a week, Bernard Madoff has reinserted the term ponzi scheme back in the public vocabulary. As we discussed earlier, these schemes are a lopsided business model and have been victimizing investors and the public for decades. Various financial commentators such as Peter Schiff and Max Keiser are beginning to echo sentiments that the U.S. economy is, in hindsight, resembling a larger scale ponzi scheme itself.
Shifting our focus back on the man who brought back our attention to this economic phenomenon, one has to wonder at the motivations and circumstances that created the Madoff scandal. Ponzi schemes are nothing new but every new incarnation doesn’t cease to disturb me. This Madoff caper in particular has three things I find bothering.
The first thing that disturbed me about the Madoff case is the high-profile nature of the parties that were affected by it. Madoff’s client list reads like a who’s-who-of-the-elite in the U.S.
Fox News reported that wealthy socialites comprised Madoff’s list of ruined clients:
Many of his investors came from the enormously wealthy enclaves of Palm Beach, Florida and Long Island, New York, where people had invested billions in Madoff’s firm for decades. He was a fixture on the Palm Beach social scene, and was a member of some of its most exclusive clubs, including the Palm Beach Country Club and Boca Rio Golf Club, where he drummed up much of his business.
The Wall Street Journal describes Madoff as a household name among elite circles:
During golf-course and cocktail-party banter, Mr. Madoff’s name frequently surfaced as a money manager who could consistently deliver high returns. Older, Jewish investors called Mr. Madoff “ ’the Jewish bond,’ ” says Ken Phillips, head of a Boulder, Colo., investment firm. “It paid 8% to 12%, every year, no matter what.”
Evidently, the ability to make money grow consistently is a somewhat of a nectar to the rich folk, and arguably was the key in creating the brownie points for Madoff’s pedigreed credibility. In an analysis that Andy Kessler of Forbes on the Madoff tale, he drew some similar points in qualifying Madoff’s motivations in this context:
Madoff was just another schlub (“worthless oaf” for you Yiddish-challenged) from New York with money. Get in line. Schlubs are a dime a dozen in the Sunshine State, contributors of hanging chads and everything.
So Madoff got the brilliant idea to start a money management business on the side. He didn’t charge any fees, explaining that he would just make money trading stocks on the securities side of the business. Merrill Lynch (nyse: MER – news – people ) and every retail brokerage player perfected this business model years ago–it’s called churning.
And the gerries fell for it. Now, all of a sudden, Madoff is a macher (a big shot, a mover). The ability to make someone money moves you to the top of the cocktail-party list. Madoff didn’t advertise; he kept it exclusive, adding to its mystery and allure. And he didn’t swing for the fences, he “produced” tortoise-like (steady) returns: 13.72% one year, 9.82% another. Goldilocks-esque. Not too hot or cold, just right.
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Which leads me to the second thing that disturbs me about the Madoff: given his credibility, what could have motivated him to intentionally defraud people? Neil Weinburg did an interesting commentary on the mind of Madoff which gives one plausible angle:
While details of Madoff’s wrongdoing are just emerging, my guess is that his entry into a life of crime also fit the standard pattern for corporate crooks. With a highly successful broker/dealer business already operating, it seems highly unlikely that Madoff woke up one morning, looked himself in the mirror and said “Today I’m going to defraud investors!”
Instead, my guess is that Madoff, like Pavlo, took his first step down the slippery slope of white-collar crime with the intention of maintaining a reputation as a can-do guy. With Pavlo, that initially involved making his department’s numbers by cutting accounting corners and eventually graduating to outright theft.
Madoff probably started managing money with the best of intentions, but at some point came up short in the performance category. That presented him with a dilemma: Disappoint his investors–something can-do guys loath–or fudge his numbers a bit. My guess is that early on Madoff told himself he’d put the money back when things got better. Instead they got worse, so Madoff borrowed a little more and a little more.
Like most corporate criminals, Madoff probably realized he had morphed into an outright fraudster only after it was too late to turn back. At that point, he could either blow the whistle on himself, wreck everything he’d spent a lifetime building and go to prison, or perpetuate his crimes in the hope that somehow, some day he’d concoct a way to trade himself out of trouble.
Although strange, but a highly regarded financial expert such as Madoff could have inadvertently turned to fraud with the best intentions. Another way of saying: “He was trying to be so good, he became bad.”
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If we trace the picture all this is painting to its logical root: Madoff’s biggest enemy was himself and his inability to be honest with himself and his investors: and this is a problem that he does not have exclusive monopoly on. Denial, especially when the social consequences are high, is a tendency we all share.
Which leads this to the third thing I find bothersome about the affair: who should protect us from ourselves? Bernard Madoff was not an overnight success, but until he disclosed his fraud, no one, not even the SEC, saw through it. As Liz Moyer writes:
In a statement late Friday, the SEC said its enforcement team probed the firm in 2007 and recommended no action. Many have said in recent days they saw clear warning signs at the firm–its extraordinarily even returns, the secretiveness with which Madoff managed the money, the fact that others could not replicate the firm’s stated investment strategy–but no one stopped it until it was too late.
Arguably part of the reason the elite paid Madoff time with their wealth is precisely because until recently, his reputation was clean.
From all this, I can only reiterate my marvel at how ideas evolve and shape our view of things. Credibility, like Madoff’s credibility, is an idea. What is staggering about these events apart from the scale of financial losses, is the realization that what we presently view as true, is nothing but a notion of truth. What the ongoing financial crisis is painfully teaching us is how truth can change and since these truths have a monetary equivalent: how changing truths can literally change lives, hopefully for the better, but in these cases: for the worse.
Even the U.S. economy wasn’t spared by Madoff. The investor losses from his fraud will now eat up on expected tax revenues, at a time when the U.S. government sorely needs them:
Investors who lost their fortunes in Madoff’s alleged Ponzi scheme will end up paying far less in taxes and may even be eligible for refunds, according to accounting experts.
By some estimates, the Internal Revenue Service could be out as much as $17 billion in lost tax revenue.
“This is one more thing federal, state and local officials will have to deal with,” said John Berrie, a tax partner at the law firm Bryan Cave in New York City. “It’s another heavy box on their back.”
In addition, investors may be counting on a federally mandated insurance fund to bail them out, but that program lacks the money to pay for all the claims that are likely to come.
The timing couldn’t be worse. Unemployment has surged, meaning fewer workers are paying payroll taxes. And housing prices have dropped, reducing property taxes.
The recession so far has cost the federal government $200 billion in tax revenues for the 12 months that ended in November, according to estimates by Moody’s Economy.com.
