Two days ago the FBI indicted Bernie Madoff, principal of Bernard L. Madoff Investment Securities LLC, on securities fraud. Though the case has yet to run, in the indictment the FBI reported that Madoff confessed that his was “basically a giant Ponzi Scheme”  that may have lost some extremely high net worth individuals over US$50 billion.

Madoff’s firm was famous for returning constant positive results, even on a month by month basis, for decades. As Henry Blodget on Yahoo’s Tech Ticker reports below, many Wall Street professionals were incredulous of these results, but invested in his firm anyway–because they thought his returns must be coming from him exploiting his “market maker” role on the Nasdaq to do insider trading.

This in itself is a delicious commentary on the oxymoron of self-regulating financial markets. Insider trading is illegal, but many bigwigs on the Street were quite willing to risk their money with someone whom they thought could only be making that much money if he were breaking the law.

In fact, he was breaking the law, but not that way: rather than making profits from insider trading and then funnelling part of the proceeds to those who gave him the funds with which to do it, he was simply taking in principal from “investors” and paying it back to them as interest.

This is what qualifies his (alleged) activities as Ponzi Scheme, named after Charles Ponzi,* whose dream of a means to get rich quick by arbitrage on International Reply Coupons (IRC) turned into a giant financial fraud.

* Incidentally, while I link to the Wikipedia entry on Ponzi and his scheme, it’s somewhat inaccurate on Ponzi’s early history, and also leaves out important attenuating facts about him. By far the best reference is the brilliantly researched and beautifully written Ponzi’s Scheme: The True Story of a Financial Legend by Mitchell Zuckoff. Read it and you will learn that, in addition to turning into a somewhat inadvertent but large scale swindler, Ponzi also literally gave the skin off his own back–and on two separate occasions–to save the life of a nurse who had suffered horrific burns. I can’t see many of those accused of running a Ponzi Scheme these days giving anyone the shirt off their backs, let alone their own skin.

Ponzi believed he had stumbled on a path to riches when he received an IRC in the mail and then found that it was mispriced around the world. IRCs were designed to facilitate communication. Person A in country X could write to person B in country Y, and enclose an IRC that person B could then exchange for a postage stamp for the reply.

Great idea, except that the prices were set before the First World War, and not adjusted after it. For argument’s sake, let’s say the price for an IRC was 1 dollar in the USA and 1 lira in Italy, and the exchange rate in 1910 was 1 dollar for 1 lira.

Then along comes WWI and currencies go haywire–say now that a lira is only worth ten cents. But it still buys one IRC in Italy, which if shipped to the USA will then be exchangeable for a $1 stamp.

Ponzi thought that he could:

  1. Raise dollars in the USA
  2. Ship them to Italy
  3. Exchange them for Italian Lira–$1 buying 10 lira (let’s say)
  4. Buy 10 IRCs with the 10 Lira
  5. Ship the IRCs back to America
  6. Sell them to people who were going to buy them at the Post Office for (say) half price
  7. Make a fortune…

Great idea, except that the great financial journalist Clarence Barron calculated that, to support the scale of investments in Ponzi’s Scheme towards its end, there would need to be 160 million IRCs in circulation; but there were in reality only 27 thousand to be had.

An awareness that this might be the case was probably why Ponzi couldn’t convince the big end of town to invest–remember the old adage “If it sounds too good to be true, it probably is”? (something the “investors” in Madoff’s firm obviously forgot). So he set up a shop front, promising retail investors a 50 percent return on their money in 45 days.

Some people who didn’t know the adage took a punt, and within days Ponzi had his first funds–well before he worked out the mechanics of his arbitrage scheme. When 45 days elapsed and the first “investor” turned up expecting his $50 return on a $100 investment, Ponzi gave him money the only way he could–by handing over some of the money initially deposited by those early investors.

“Wow! Ponzi makes good on his promise: invest $100, and seven weeks later earn $50. Why if I left that $100 with him–or better still, left that AND added the $50 he’s just given me (minus say $25 for a good night out in celebration), then in another seven weeks I’ll have $187.50. And if I re-invest that…”

So went the word, as successful investors in Ponzi’s Scheme bragged to their friends about how much money the nice Mr Ponzi had made them.  Ponzi never got the mechanics of the IRC arbitrage scheme worked out–and he continued to dream up schemes that, if they succeeded, would mean his apparent dividends were actually legitimately earned–and stuck with the practice of paying out principal deposited by later investors as interest to earlier ones.

Ultimately, he took in something close to US$15 million from about 40,000 people. Some of them who got out early walked away a lot wealthier, but at the end of the scheme, those still in it could only recoup $5 million–the other $10 million had gone to the early escapees, and to fund Ponzi’s temporarily luxurious lifestyle and minimal operating costs.

On some scales, Madoff’s is a more modest scheme than Ponzi’s–rather than promising 50% every 45 days (which works out at an annual rate of return of 2,680%), Madoff returned investors roughly 1% a month. As a result, the Big End of Town could persuade itself that the returns were initially the result of a successful investment strategy–and then later as the sheer volume grew, that they were the result of insider trading.

So Madoff attracted really wealthy investors: it appears that his firm “managed” over US$17 billion for less than 100 investors–though Madoff himself allegedly estimated his total losses at US$50 billion. And the scheme ran for almost half a century–far longer than Ponzi’s brief time in the financial sun (less than a year).

So is this the World’s Biggest Ponzi Scheme, as some headlines are trumpeting?

It’s certainly the biggest of what I call Type I Ponzi Schemes: direct, undisguised schemes in which principal is paid out as interest. But the biggest Ponzi Schemes by far are what I call Type II: here, instead of a direct “principal in, interest out” pump, we have “borrow money, buy assets with it, drive up the asset price, sell the assets, pay off the debt plus interest, and keep part of the asset price appreciation as profit”.

That, of course, describes margin lending on the stock market, and above all, leveraged speculation on house prices. It works a treat while asset prices continue to rise, but a fundamental precondition for this is that the level of debt has to rise even faster–since interest on the debt compounds it, and no real money is being made (by doing boring stuff like producing widgets and flogging them for a profit–the legitimate equivalent to Ponzi’s never-practised arbitrage scheme).

It falls over when the next entrant into the scheme looks at the level of debt required to enter, compares it to his/her income, says to self “there’s no way I could ever repay this out of my income” and decides not to play.

In reality, the world’s financial system has become one giant Type II Ponzi Scheme, and we are now reaping the whirlwind of that fiasco. While some made a fortune by getting out early, others are locked into the downward spiral as asset prices  plummet for lack of buyers, excessive debt, and distressed selling to meet interest payments, and margin calls.

Madoff’s (alleged) Ponzi Scheme may be the most dramatic Ponzi Scheme, but in reality we’ve all been for a ride in Ponzi’s Magical Mystery Machine.

Part of the appeal of it all is the sheer fun of the boom. As Ponzi himself put it when interviewed on his deathbed in a Brazilian hospital for the destitute:

“Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over.”

Below are some early reports on Madoff’s Scheme. I’ll continue adding to them as they come in–though at some stage there will doubtless be a flood that I can’t keep pace with.

December 12: Yahoo Finance Tech Ticker: “I Knew Bernie Madoff Was Cheating; That’s Why I Invested with Him“. “So why did these smart and skeptical investors keep investing? They, like many Madoff investors, assumed Madoff was somehow illegally trading on information from his market-making business for their benefit. They didn’t consider the possibility that he was clean on that score but running a good old-fashioned Ponzi scheme.”

December 12: More on Madoff and the world’s biggest explicit Ponzi Scheme (in reality both the stock market and housing market bubbles were also Ponzi Schemes) The World’s Biggest Ever Heist. “Right now, there are a handful people whose world has suddenly been turned upside-down: who have, overnight, suddenly lost billions of dollars of dynastic wealth to a Wall Street con man. I’m sure that their names will appear sooner or later. But there really is no precedent that I can think of: when has one man ever managed to steal $50 billion dollars? If the $100 million Harry Winston heist in Paris was the “steal of the century”, what’s this?.”

December 11: Henry Blodget on Clusterstock: Bernie Madoff: The Indictment. “The criminal indictment of Bernie Madoff is embedded below. The good stuff starts at the bottom of page 2, when the FBI agent begins talking about his interview with two of Bernie’s senior employees. According to the WSJ, these two employees are Bernie’s sons. Also don’t miss the last paragraph, where the agent interviews Bernie himself.”

December 11th: Prominent Trader Accused of Defrauding Clients, NY Times. “On Wall Street, his name is legendary. With money he had made as a lifeguard on the beaches of Long Island, he built a trading powerhouse that had prospered for more than four decades. At age 70, he had become an influential spokesman for the traders who are the hidden gears of the marketplace. But on Thursday morning, this consummate trader, Bernard L. Madoff, was arrested at his Manhattan home by federal agents who accused him of running a multibillion-dollar fraud scheme — perhaps the largest in Wall Street’s history…”

“Mr. Madoff invited the two executives to his Manhattan apartment that evening. When they joined him there, he told them that his money-management business was “all just one big lie” and “basically, a giant Ponzi scheme.”

“The senior employees understood him to be saying that he had for years been paying returns to certain investors out of the cash received from other investors.”

Check the Madoff Client Database to see Madoff’s identified victims, complete with a map of there locations. Amazing!