The biggest financial fraud in history?

When someone told me today what Bernard Madoff had done, I couldn’t understand how such a thing was possible. How could Madoff have had enough money on hand to keep paying his existing investors their handsome dividends—from investments that actually didn’t exist because those investments, instead of being invested in actual securities and producing actual dividends, had gone to pay the supposed dividends of other investors, whose investments, in turn, had gone to pay the supposed dividends of other investors? And the answer was, he was able to keep the whole thing afloat because, as a result of his great reputation, he had so much money coming in from new investors. So, while his investors were happily receiving their nice dividends—“his unnaturally steady returns,” as the New York Times describes it—all of their principal was gone with the wind, having been paid to other investors. You could imagine such a thing going on for a few months, or maybe a couple of years, but this went on for decades—and involved fifty billion dollars. It must be the biggest financial fraud in history.

Another question: wouldn’t all the employees of Madoff’s firm have to have been in on the scheme? After all, the $50 billion in investments they were spending their working days handling, year after year, didn’t bleeping exist.

From the Times:

On Thursday, the Federal Bureau of Investigation and S.E.C. said that Mr. Madoff’s firm, Bernard L. Madoff Investment Securities, ran a giant Ponzi scheme, a type of fraud in which earlier investors are paid off with money raised from later victims—until no money can be raised and the scheme collapses.

Most Ponzi schemes collapse relatively quickly, but there is fragmentary evidence that Mr. Madoff’s scheme may have lasted for years or even decades….

Investors may have been duped because Mr. Madoff sent detailed brokerage statements to investors whose money he managed, sometimes reporting hundreds of individual stock trades per month. Investors who asked for their money back could have it returned within days. And while typical Ponzi schemes promise very high returns, Mr. Madoff’s promised returns were relatively realistic—about 10 percent a year—though they were unrealistically steady.

Mr. Madoff was not running an actual hedge fund, but instead managing accounts for investors inside his own securities firm. The difference, though seemingly minor, is crucial. Hedge funds typically hold their portfolios at banks and brokerage firms like JPMorgan Chase and Goldman Sachs. Outside auditors can check with those banks and brokerage firms to make sure the funds exist.

But because he had his own securities firm, Mr. Madoff kept custody over his clients’ accounts and processed all their stock trades himself. His only check appears to have been Friehling & Horowitz, a tiny auditing firm based in New City, N.Y. Wealthy individuals and other money managers entrusted billions of dollars to funds that in turn invested in his firm, based on his reputation and reported returns.

Victims of the scam included gray-haired grandmothers in Florida, investment companies in London, and charities and universities across the United States. The Wilpon family, the main owners of the New York Mets, and Yeshiva University both confirmed that they had invested with Mr. Madoff, and a Jewish charity in Massachusetts said it would lay off its five employees and close after losing nearly all of its $7 million endowment. Other investors included prominent Jewish families in New York and Florida….

Robert Rosenkranz, principal of Acorn Partners, which helps wealthy clients choose money managers, said the steadiness of the returns that Mr. Madoff reported did not make sense, and the size of his auditor raised further concerns.

“Our due diligence, which got into both account statements of his customers, and the audited statements of Madoff Securities, which he filed with the S.E.C., made it seem highly likely that the account statements themselves were just pieces of paper that were generated in connection with some sort of fraudulent activity,” Mr. Rosenkranz said.

Simon Fludgate, head of operational due diligence for Aksia, another advisory firm that told clients not to invest with Mr. Madoff, said the secrecy of his strategy also raised red flags. And Mr. Madoff’s stock holdings, which he disclosed each quarter with the Securities and Exchange Commission, appeared to be too small to support the size of the fund he claimed. Mr. Madoff’s promoters sometimes tried to explain the discrepancy by explaining that he sold all his shares at the end of each quarter and put his holdings in cash.

“There were no smoking guns, but too many things that didn’t add up,” Mr. Fludgate said.

However, the S.E.C. had already investigated Mr. Madoff and two accountants who raised money for him in 1992, believing they might have found a Ponzi scheme. “We went into this thing just thinking it might be a huge catastrophe,” an S.E.C. official told The Wall Street Journal in December 1992.

Instead, Mr. Madoff turned out to have delivered the returns that the investment advisers had promised their clients. It is not clear whether the results of the 1992 inquiry discouraged the S.E.C. from examining Mr. Madoff again, even when new red flags surfaced.

According to an S.E.C. statement released on Friday night, the agency looked at Mr. Madoff’s operations twice in recent years—in 2005 and 2007. The 2005 review found only three technical violations of trading rules. The 2007 inquiry found nothing that prompted the regional enforcement staff to take further action by referring the matter to Washington, the statement said.

Meanwhile, Fairfield Greenwich Group, whose clients have $7.5 billion invested with the Madoff firm, said it was “shocked and appalled by this news.”

“We had no indication that we and many other firms and private investors were the victims of such a highly sophisticated, massive fraudulent scheme.”

At the court hearing, an individual investor, who declined to give his name to avoid embarrassment, expressed a similar sentiment.

“Nobody knows where their money is and whether it is protected,” the investor said.

“The returns were just amazing and we trusted this guy for decades—if you wanted to take money out, you always got your check in a few days. That’s why we were all so stunned.”

Posted by Lawrence Auster at December 13, 2008 11:11 PM | Send