Madoff, Our Latest Ponzi Scheme Creator

Bernie Madoff recently made headlines after the government discovered that his company, Bernard L. Madoff Investment Securities LLC, had defrauded investors out of $50 billion dollars. His company is accused of hiding massive investment losses from regulators and clients over the past several decades.  Madoff LLC hid the losses through falsified accounting statements.  Madoff has confessed, as he explained to FBI officers, "there is no innocent explanation."

So how did Madoff get away with hiding his investment losses over a long period of time? Even as his company lost money, his popularity attracted many new investors who were confidently giving money to a man who had an excellent, though ultimately false, reputation for producing steady, positive financial returns.  He used money from new investors to operate his business and payoff older investors who wish to withdraw funds.  Madoff attracted new investors with his promise of a low but steady percentage of growth, like 1% a month, his social status

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, and his falsified track record.  He kept existing investors happy by sending his clients false statements to make them believe he was delivering. As long as Madoff was able to acquire new customers, he had the funds to give to older investors. This type of operation is called a Ponzi scheme, named after Charles Ponzi, an American businessman who became famous for a similar scheme that involved selling postage stamps.

The most disheartening fact about the whole scam is how so many people respected Madoff. Nobody had been publicly questioning his reputation - and his positive reputation made it easy for him to acquire new investors.  There were people questioning his business.  In the finance industry, there are companies that specialize in evaluating investment firms. These companies, which provide "due diligence" services that determine whether a firm is operating legitimately. Several "due diligence" firms raise red flags - Madoff LLC's performance was too good to be true - it always posted profits in its statements. Even a handful of others complained to the SEC.  However, these complaints did not result in an investigation through enough to uncover fraud.  The red flags raised did not lead to an end of the scandal.

The biggest losers from the Madoff scandal will be the clients who ultimately invested in him, many who willingly invested indirectly.  Few companies were permitted to directly invest with Madoff, the companies chosen were "feeder funds," funds that took investments from a larger number of parties wanting to invest with Madoff, indirectly.  Madoff reinforced this system by limiting who could directly invest with him.  The list of organizations that ultimately have lost money, who are suffering from the $50 billion dollar scam, is small, relatively, but includes an interesting mix of charities, banks, and wealthy individuals. Most of the end investors knew they were investing with Madoff.  The scandal pronounces ever more how hard it is to find people to trust with your money. Public reputations don't always tell the full story.

Madoff was extremely polished and government agencies took a long time to catch on.   It's hard to detect frauds that are smooth, who meet the image expectations we as individuals hold up as "trusted businessman."  As an investor, the only protection available against fraudster is due diligence and skepticism.  If it sounds too good to be true, like "proven 1% growth every month," the old saying "it's too good to be true" applies.  Not that optimism is a red flag - some of the best investors simply aim to beat the market's average rate of return by a few percentage points - it's just that anyone claiming to have always have done this is suspect.