I’ve written before about Ponzi schemes, but having recently read (and been a bit bored by) the book in the title, I felt that it might be time to revisit that post and put it in context.
What is a Ponzi Scheme?
A Ponzi Scheme (and/or Pyramid Scheme*) occurs when the investment manager uses new money from new investors to pay “returns” to old investors. That is: no real returns take place.
*there’s a minor difference between the two – but technicalities are not so important to this principle.
Step 1: get investors, take their money.
Step 2: get more investors, take their money, use that money to pay returns to the investors from Step 1.
Step 3: get more investors, take their money, use that money to pay back the investors from steps 1 and 2.
Step 4: and so on.
As you can see, we’re rapidly getting back to that whole problem with exponentials and unanticipated math? Because the above pyramid actually shows rapidly decreasing returns over time (in step 2, the investment of three people is being used to pay back two people; in step 3, the investment of four people will be used to pay back five people – being two from step 1, and three from step 2).
If the Ponzi operator wanted to maintain returns over time, he/she would have to take on new investors at an exponential rate: 2 4 8 16 32 64 128 256 512…
And that rapidly becomes unsustainable.
Why is the Bernie Madoff Scheme so interesting?
Because it lasted such a long time! According to Mr Madoff, he was doing the above (almost literally – there was nothing spectacularly unique about the way he did it) for almost 20 years. Which is an incredibly long time to continue happily collecting new money and distributing it to old investors.
The secret, it seems, is to deliberately target charitable organisations with large endowments. Under federal law, these institutions have a “5% payout rule”, under which that are required to spend 5% of their invested capital each year (or else they lose their no-tax privileges, or something). So for every $1 billion that Bernie was holding in his Chase Manhattan bank account, he was only required to pay out $50 million each year. And because charities are not famous for spending more than that, the Madoff scheme was largely protected from unexpectedly large and sudden withdrawals (the way that most Ponzi schemes collapse).
And who is Harry Markopoulos?
Bernie Madoff didn’t earn spectacularly high returns. He just earned impressively consistent returns, regardless of how badly the market was doing. He claimed that he was doing it by taking out both put and call options on the investments he was making (ie. he would take out insurance policies on every investment he made to ensure [insure?] that he never lost money).
Anyway, there are lots of investors out there who aren’t interested in making big wins – they just want to not lose anything (investors like charities with large endowments…). So there is big business attached to seemingly “safe” fund managers that generate consistent returns.
Other investment firms in Wall Street began to take notice of Madoff’s performance, and hired financial analysts to try and replicate his strategy.
Harry Markopoulos was one of them.
And no one could replicate the strategy.
What everyone thought?
Most traders assumed that Bernie Madoff was front-running his trades (the kind of illegal activity where you know that someone is about to make a giant purchase/sell, so you go in and buy/sell that share immediately before they do, and get to profit off the swing in the market price caused by their trade).
And just to be clear, none of the big investment firms were investing their money with Bernie. Most people knew that something was not right.
Mr Markopoulos, however, seems to have developed something of a quest mentality around the Madoff scheme. He figured out very quickly that the trades could not be replicated, even with front-running.
And in 1999, he handed the SEC a whistle-blowing document that laid out calculation after calculation to demonstrate that Bernie Madoff was running a Ponzi Scheme.
The SEC did nothing.
They would do nothing after a further two reports from Mr Markopoulos, who began to attract the reputation of being a bit of a crazy (probably not altogether unwarranted – who gives ten years of their life to trying to bring down a guy just because the math doesn’t add up?).
And when the Madoff Scheme eventually collapsed, Harry Markopoulos embarked on what has to be one of the most elaborate and distasteful I-Told-You-So dances that have ever been danced.
I mean – truly.
No One Would Listen
Part of that was his book: “No One Would Listen: A True Financial Thriller”.
Let me tell you right now: not that thrilling. It’s a 200 page rant about the uselessness of the SEC and everyone else that didn’t listen, with oh-so-much repetition about the uselessness of the SEC.
We get it. The SEC is political. Bernie Madoff was well-connected. So the SEC did nothing.
Also: the SEC is filled with all the underpaid fails from Business School, who don’t have the energy or the inclination to read through pages of a mathematical brief that involve plenty of assumptions and stuff.
That said: the book is worth skimming over. Just try to avoid all the ragey rhetoric!