Ponzi scheming

  • Living
  • Sunday, 07 Feb 2016

In 2008, Bernie Madoff was arrested for running a hedge fund that turned out to be the largest ponzi scheme the world had ever seen. After more than a decade of operation, the amount of money missing from client accounts amounted to almost US$65bil.

Even more amazingly, suspicious deficiencies in the scheme had been identified as early as in the year 2000, and its allegations were made known over to the US Security Exchange Commission (SEC). But it took eight years before Madoff was put under arrest.

At its most simple, a Ponzi scheme is when somebody pays profits to earlier investors by using money from later investors. The early birds then take this as a sign that the scheme is delivering what it promises, and either invests more money, or encourages their family and friends to also take part in the scheme. Because profits depend on getting new investors, when people stop investing, the scheme collapses dramatically.

An analyst named Harry Markopolos was asked by his superiors at Rampart Investment Management to design a similar product so that they could offer their investors similar returns of 12% a year.

However, when Markopolos took a closer look, the numbers just didn’t add up. He concluded that Madoff was either “front-running” the order flow – a form of insider trading – or he was running a Ponzi scheme.

Markopolos reported this to the SEC in May 2000, and again in March 2001, eventually culminating in October 2005 when he delivered a 25-page report that highlighted 30 “red flags” that Madoff was up to no good. However, each time the SEC failed to catch Madoff in the act.

How did this happen? After the Madoff affair came to light, the SEC conducted an internal investigation examining the shortcomings of their investigation. It concluded that the teams were “relatively inexperienced” and that the majority of the work in the 2005 investigation was conducted by a “staff attorney who recently graduated from law school”.

The report also said that there were “no significant attempts made to analyse the numerous red flags”. And when they did discover something, they simply asked Madoff directly about the contradiction or inconsistency, but “even when Madoff’s answers were seemingly implausible, the SEC examiners accepted them at face value”.

Why had the SEC performed so poorly? Intriguingly, the first paragraph of the investigation report was adamant that nobody in the SEC had “any financial or other inappropriate connection with Bernie Madoff”. This is despite the fact the Madoff family moved in high financial circles.

It wasn’t as if nobody knew something was wrong.

Apart from Markopolos, there were at least two articles in well-regarded financial magazines that doubted Madoff’s investment strategies, and Markopolos himself highlighted this: “I have... spoken to heads of various Wall Street equity derivative trading desks and every single one of the senior managers I spoke with told me that Bernie Madoff was a fraud”, and claimed that none of the equity derivatives trading heads at Morgan Stanley, Goldman Sachs, JP Morgan and Citigroup would invest with Madoff.

In the end, Madoff was reported to the authorities by his own sons, who claimed they had no idea their father was a criminal until he admitted to them that he had conducted this fraud.

People around the world were caught out. Banks were complicit and had to compensate their clients to the tune of billions. Several charities who had together entrusted more than a billion dollars to Madoff had to be closed down. One of the founders of Access International Advisors LLC, who had invested three-quarters of the company’s funds with Madoff, as well as all of his personal wealth, committed suicide within a few weeks of Madoff’s arrest.

Why hadn’t Markopolos just gone public earlier? Would all these people have been spared much pain? Markopolos admitted that although many knew something was fishy, “no one wants to take undue career risk by sticking their head up” and had even made sure his name was not anywhere on the report he submitted.

It was a combination of factors. Suspicious dealings that nobody except the experts really understood. Connections to higher ups in the authorities tasked to find wrongdoing. Investigation by authorities that were not quite up to the mark. And a lack of solid, critical public discussion about the issues.

In Malaysia, we are facing many issues that need independent analysts who are competent and impartial.

Sometimes it works. Sometimes there is open debate.

For example, Former UN Assistant Secretary-General Prof Dr Jomo Kwame Sundaram’s piece in The Star (“Reconsider TPPA in public interest”/Feb 3) was an informative piece arguing against the Trans-Pacific Partnership Agreement (TPPA). But at other times, when we hope the press can disseminate reasoned analytical pieces, instead of in-depth reports, we get politicians parroting soundbites.

Yes, I can turn to the Internet to get my share of sceptical analyses, but I also would like it run through a sanity filter.

This is what the press can do – they can provide a nuanced view of the news rather than just focus on quotable quotes. It is unlikely that the issues we face here are quite on the same level as the Bernie Madoff case, but I’d rather we get ahead of the problem than to read about its unfortunate fallout in the news.

Logic is the antithesis of emotion but mathematician-turned-scriptwriter Dzof Azmi’s theory is that people need both to make sense of life’s vagaries and contradictions.

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Ponzi scheming


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