World's Largest Ponzi Scheme - The Bernie Madoff Scandal

BY DISHA DORUGADE

Ponzi schemes have been around a long time dating back to the 1920’s. This fraudulent investing scam pays existing investors with funds collected from new investors. In 2008 Bernie Madoff who was a wall street investment advisor, at that time, was arrested for running a multi-million dollar ponzi scheme, which was probably the largest ponzi scheme in history. It was estimated that he had been operating the scam for more than 20 years which was worth around 50 billion dollars.

Madoff started by forming a business in 1960, Bernard L. Madoff Investment Securities LLC, with the money that he earned from working as a lifeguard and sprinkler installer. With the help of his father-in-law, accountant Saul Alpern, his business began to grow and became one of the largest penny stock brokerage and wealth management firms. To be a step ahead of its competition, Madoff’s company started using computer information technology which was later adopted by the NASDAQ stock exchange. Madoff was well respected in Wall Street. He also became the chairman of NASDAQ in 1990 and served in 1991 and 1993 as well. His children and several members of his family worked with him in his investment securities company.

Madoff claimed to use the split strike investment strategy which involves selling an out-of-the-money call and using the proceeds to buy an OTM put for every 100 shares that you own. This minimizes risk by diversifying the portfolio.

In a ponzi scheme, organizers promise substantial returns to the investor and focus mainly on getting new clients to invest as it requires constant flow of new money for the scheme to survive. The money from the new investors is used to pay off the old investors to give a false impression that the posed scheme is earning actual returns, which is what Madoff did. He deposited the cash obtained by the investors into his personal bank account and paid returns to earlier investors using the money invested by the newer investors.

Harry Markopolos, a financial analyst and portfolio manager at Boston options trader Rampart Investment Management, played the role of the whistleblower in this scam. In May 2000 he grew suspicious about Madoff’s returns in the scheme as it was impossible to generate the returns Madoff obtained using the strategy he claimed to use, hence Markopolos alerted the Securities exchange commission (SEC). Even after receiving multiple warnings the SEC failed to take any significant action. Madoff’s own firm was its hedge funds broker, unlike most hedge funds in which a bank or brokerage act as the fund’s broker. The detailed structure of Madoff's hedge funds and all the other details were not completely transparent. As there were no trades conducted at all with the money obtained from the investors, the SEC would not have been able to detect the fraud .

Things began to crumble in 2008 as the market was declining rapidly and investors wanted to cash out their investments. Hence it was challenging to keep up the ponzi scheme. Madoff was unable to borrow money from any of his contacts. Realising that he couldn't keep operating the scheme, in December of that year, he informed his sons Mark and Andrew about the fraud. His sons, after informing their lawyers, revealed their fathers plan to the federal prosecutors and the SEC. Madoff was arrested the following morning and was sentenced to a 150-year prison term in 2009.

The confusing part about this scandal is why Madoff ever got involved in this fraud as his legitimate investment business was extensively successful. Ponzi schemes do not usually sustain for a long time. They are meant to fall eventually as they never actually generate sustainable returns. Despite this, Bernie Madoff was able to operate this scam for decades. The estimated length of the fraud was said to be at least 17 years, although the documents indicated that the fraud was being operated since 1960.