Madoff’s hedge fund: A giant Ponzi scheme

Updated December 31, 2009

For years doubters on Wall Street said the returns of Bernard Madoff’s hedge fund were too good, too steady and his operation always looked too slim for the tens of billions of dollars it was managing. However, given Madoff’s experience and past service the wealthy kept giving him their money. Now it looks like those concerns were right all along now as the Bernard Madoff scandal was unmasked.

Bernard Madoff, a former chairman of the Nasdaq Stock Market, was arrested Dec. 11, 2008 and charged criminally at federal court in Manhattan with securities fraud in masterminding a massive Ponzi scheme. Following the federal prosecutors’ charge, the Securities and Exchange Commission also has brought civil charges in the matter.

Madoff, 70 years old with more than four-decades of experience as trader, allegedly confessed to senior employees that the firm's investment-advisory business was "basically a giant Ponzi scheme”, which also known as a pyramid scheme. The suspiciously smooth returns of his hedge fund was achieved by running a pyramid scheme in which existing clients’ returns were topped up, as needed, with money from new investors.

According to court documents, Madoff confessed that the fraud could top $50 billion. The $50 billion loss still can’t be confirmed but it has been called the largest Ponzi scheme in history. At a minimum, it appears the $17 billion that Madoff claimed to have under management earlier this year is all but gone.

Among victims are prominent billionaires, thousands of wealthy retirees, a cluster of mostly Jewish charities, and dozens of supposedly sophisticated financial firms. Ironically many of the investors in Madoff’s hedge fund were so-called fund of funds, which are investment vehicles that invest in a wide array of hedge funds to spread around the risk of anyone hedge fund collapsing or incurring steep losses. Some banks lent heavily to funds of funds that wanted to invest.

He is serving a 150-year prison sentence after admitting that he operated a giant Ponzi scheme for at least two decades, cheating thousands of individuals, charities, celebrities and institutional investors out of billions of dollars.

Layers of players and fees

The alleged fraud has put the heat on so-called feeders, giant hedge funds that funneled more than $20 billion to Madoff. But it turns out those feeders depended on another group of smaller funds and individuals to gather money. The largely unregulated crowd, including accountants, lawyers, investment managers, even doctors, opened the exclusive world of hedge funds to more investors and charged exorbitant fees for the privilege.

A lot of small investors got exposure to Madoff through sub-feeders. The system allowed investors to gain entrée to Madoff with far fewer dollars, thereby expanding his clientele beyond big institutions and billionaires to wealthy individuals of more modest means. Many small investors had no idea what they were buying since marketing documents rarely mentioned Madoff by name.

Fees were collected at every level. Investors paid layer upon layer of fees with seemingly little regard for how they ate into gains. Those at the bottom paid the biggest tab and realized the smallest returns; and only see their investments vanished.

Red flags

The SEC and the hundreds of investors Madoff deceived appear to have missed some red flags. Only few potential investors examined Madoff's operation and declined to invest.

The secrecy with which the investment business was conducted possibly the major warning sign. It was a black box, run by a tiny team at a very long arm’s length from the group’s much bigger broker-dealer. Clients were kept in the dark.

The returns Madoff achieved were too good and suspiciously smooth. He had described his investment strategy as a simultaneous purchase of stock and sale of option contracts. But investors missed an important piece of clues that there wasn't sufficient volume in those options trades to account for the reported gains.

Financial crisis exposed Madoff’s scam

In the end, like most Ponzi schemes, Madoff’s scheme collapsed when too many investors sought to pull their money out at the same time, and the operator didn’t have the cash on hand. Just like many hedge fund operators, in recent months Madoff received a wave of redemption notices from investors looking to preserve cash. Authorities say investors sought to pull-out from the fund some $7 billion, money Madoff apparently did not have.

It appears Madoff’s scam ultimately was uncovered by the worst financial crisis in U.S. since the Great Depression, as it has dried-up all sources of liquidity and investors are fleeing hedge funds, stocks, bonds, commodities and other asset classes for the safety of cash.

A false sense of comfort

While the Securities and Exchange Commission (SEC) oversaw Madoff’s investment business, the commission failed to carry out any examinations despite receiving complaints from investors and rivals since as long ago as the late 1990s. In 2006 one potential investor actually branded Madoff’s operation a Ponzi scheme and took his suspicions to the SEC. The agency discovered that Mr Madoff had misled it over how he managed his money, but it failed to pursue its concerns. The SEC gave Madoff a clean bill of health after he corrected some minor issues. Christopher Cox, the SEC’s outgoing chairman, has called its handling of the case “deeply troubling” and promised an investigation of its “multiple failures”.

The commission’s very existence gives many investors a false sense of comfort that a big agency is looking after their interests, argues James Grant, editor of Grant’s Interest-Rate Observer newsletter. Those who were defrauded by Madoff might have done a lot more due diligence on his shadowy investment-management business if they had known they were on their own. Only a tiny minority of few private research firms did do their homework, and found enough suspicious stuff to advise their clients against investing with him.