Ponzi Schemes Explained - In loving memory of Bernard “Bernie” Madoff
Op-Ed by Sandro Joseph Azzam, Staff Writer
April 29th, 2021
Bernard Lawrence Madoff was born in 1939 in Queens, New York City, to Sylvia and Ralph Madoff, the children of immigrants from Romania, Austria and Poland. Little did we know, he would become the world’s most hated banker.
Madoff’s parents were in a dire financial situation early on in their lives, so they decided to transition from employment in plumbing into financial services. After ending up on the wrong side of the Great Depression, Madoff’s parents moved from their old jobs into finance, becoming stockbrokers. In the 60’s they set up their own company. Just like their son’s dodgy dealings, Madoff’s parents’ business practices were questionable at best. The US Securities Exchange Commission closed down the Madoffs’ company due to the fact that Sylvia had forgotten to file a series of reports on the firm’s financial position. The apple doesn’t fall far from the tree…
Madoff graduated from Hofstra University in Long Island and managed to scrape up $5.000 that he used to set up Bernard L. Madoff Securities, LLC, along with a $50.000 loan. The rest, as they say, is history. Madoff’s company was a brokerage house – they would buy and sell securities to make sure that all the actors on financial markets were able to conduct the transactions they needed to conduct. To put it simply, if Jake wanted to sell 1 share of Coca Cola stock, that meant that someone else had to buy it. The buyers would be Madoff’s company, and they would charge Jake a small premium on each share they bought so as to compensate for their services. It also works the other way around – when Jake wants to buy 1 share of General Motors stock, he’d have to go to Madoff, who would then sell him one share for a premium.
His work within Madoff Securities allowed Bernie to make a name for himself – he was recognized as a shrewd banker within the industry, allowing him to rack up a client list spanning from Steven Spielberg to the Spanish banking juggernaut, Santander. His reputation was so pristine that he was one of the founders and even the chairman of the NASDAQ, a stock exchange that specializes in technology stocks.
Ok, ok, but how did he get himself involved in a massive scam that would end up accruing over 65 billion dollars in volume? Investigators found “inconsistencies” in the returns that he was providing to his clients around the year 2000. How exactly did he provide these returns?
He set up what is referred to as a Ponzi Scheme. Initially coined to honor (or, most likely dishonor) Charles Ponzi, this kind of financial scheme was one that would provide abnormally large returns to investors by paying recent investors with the funds from older ones. Charles Ponzi had initially promised 50% returns to investors after he held their money for 90 days. This didn’t end well when the whole system came crashing down.
Madoff’s case worked exactly the same way. He offered his investors a 12% per year return, meaning that a $1.000.000 lump sum would generate $120.000 per year. A 15% return for investors would be too high – people would question what Madoff Securities was doing. But a 5% return was too low – nobody would be tempted to join the scheme, which is why Madoff settled for 12%. Madoff told his clients that he would be investing their money into the stock market to be able to justify this 12% return and, given his pristine track record, everyone believed that he was doing exactly that. Investors were lining up to give Madoff their money as a 12% return on investment was phenomenal. Bernie only needed to make sure to keep a low profile and remain below the radar to make sure that everything would work.
Onto the inner-workings of a Ponzi Scheme. Alex, Bernadette and Charles each have 1 million dollars that they want to invest. They go knocking on Madoff’s door practically begging him to take their 1 million dollars and give them their return at the end of the year. The clients expected that Madoff would invest the combined 3 million dollars into the stock market to earn the 12% return that he’d promised. This couldn’t be further from the truth. What ended up happening was that Madoff would put the combined 3 million dollars into a bank account and let it sit there. A few weeks later, Danielle would come to Madoff to invest 1 million dollars of her own into the fund. Madoff would gladly take the money and put it in the communal bank account. At maturity, Alex, Bernadette and Charles now ask for their money back – they are each entitled to their 1-million-dollar initial investment plus the extra $120.000 interest. But Madoff didn’t end up making an extra $120.000 for each investor – what could he do? Well, there’s 4 million dollars in the community pot and Madoff needed to return 3.36 million to the investors. He would take the 3.36 million out of the pot to pay back the first 3 investors into the scheme and leave $640.000 in the communal bank account.
But you may notice a problem here – what about Danielle? She initially put in 1 million dollars and there’s only $640.000 left in the communal pot for her to get her money from. That’s where the new investor, Emma, comes into play. Emma gives Madoff 1 million dollars of her own money. Madoff takes the 1 million to pay off Danielle and adds $120.000 in interest income. This leaves Emma with the short end of the stick – a portion of her money has just gone to “bailing out” Danielle. Since Danielle’s money went to pay the fictitious gains realized by Alex, Bernadette and Charles, she was left in a deficit. The only way to plug that deficit was to give Danielle Emma’s money. But wait, that creates a new problem: what about Emma?! Well, to plug the deficit that has just been created and make up for Emma’s loss, we’d need to find a new investor, Fred. Fred swoops in, throws 1 million dollars at Bernie Madoff who is now able to give Emma her initial 1 million dollars plus the interest. But now Fred has lost a portion of his money to make up for Emma’s. Solution? Take another 1 million dollars from Georges, add it to the communal pot of money and pay Fred off.
Georges is now in the red for a large portion of his money given that a certain amount of his initial 1-million-dollar investment went to plugging Fred’s deficit. Solution? We need to find a new investor, Helen. But Helen decided not to get involved in the scheme, and neither did Isabelle, Josh, Kim, Liam or Mark. Nobody is interested in giving Madoff money anymore, which means that without the new funds, Georges ends up with the short end of the stick.
This is exactly what happened in the case of Bernie Madoff - except it was on a massive scale – with an order of magnitude of 65 billion dollars. If every individual, firm or company in the entire country of Croatia worked non-stop for a year, they would produce a total output of 60 billion dollars, 5 billion short of the sum Madoff turned over.
Regulators eventually caught a hint of what Madoff was running – his alleged 20-billion-dollar net worth was probably a dead give-away. After running the scheme for almost 2 decades, he was brought up on securities fraud charges and sentenced to 150 years in prison in December 2008. He was set to be released from prison in the year 2139 but tragically passed away on April 14th, 2021.
Madoff’s victims are still waiting for compensation with people like Georges being promised upwards of 700 million dollars granted by the Federal Government. But given the massive scale of the losses, the bigger players will virtually never recover the entirety of the money they lost. The magnitude of the losses was around 36 billion dollars, with 18 billion initially missing and the other half being returned to investors from the community pot. To this day, about 14 billion dollars have been returned to the victims through, I kid you not, the Madoff Recovery Initiative. About 4 billion dollars in losses are still left in play.
Bernard Madoff was a legend of his time and his memory will be forever ingrained in the minds of his victims, the regulators and his fans. Unlike the other, more socialist Bernie, this Bernie took money from the extremely rich to pay off the moderately rich in a scheme that would only run so long as money kept flowing into it. As long as new investors joined the game, the current clients were in the green, up until the money stopped flowing in. What’s unfortunate is that Bernie Madoff exemplifies Batman’s famous one-liner: “you either die a hero, or you live long enough to see yourself become the villain”.
Long credited for running the world’s largest Ponzi Scheme, Madoff passed away after the Lebanese banking institutions stole his crown becoming the new world’s largest Ponzi scheme. Who knows, maybe Madoff perished at the news that he had been outdone. What remains certain however is that whilst Madoff may be gone, he will never be forgotten.