Bernie Madoff’s Ponzi play: If it’s too good to be true, it isn’t true

by Kurt Schulzke on December 12, 2008

Every time I think I’ve seen the biggest scam ever, a bigger one comes galloping over the horizon.  Well, I take it back.  Bernie Madoff’s is dwarfed by TARP.  Let’s call Bernie’s the biggest scam by a single individual.  Fifty billion dollars is enough to put a dent in almost anyone’s checking account.

For lay readers, the document currently circulating as Madoff’s “indictment” is not an indictment in technical legal terms.  Indictments are handed down by grand juries.  This document is a criminal complaint filed with the court by a single complainant who, in Madoff’s case, happens to be an FBI agent.  An indictment may follow.  Whatever the nature of the document, the key lesson for readers is one that American investors, especially, seem reluctant to internalize.

Deals that seem too good to be true usually are, now matter which “savvy guy” is in charge.  In Madoff’s case, lots of otherwise smart investors apparently got it in their heads that Madoff was beating the market by cheating.  They thought, as otherwise intelligent people often do, that because Madoff was such a savvy guy — after all, he was a founder of Nasdaq! — he must have some fancy market mojo to get past those SEC and FBI stormtroopers to steal the goodies.  “Use the force, Bernie!,” or some such nonsense.

More specifically, as Henry Blodget writes, some of his investors figured that Bernie was getting such high returns by trading on inside information.  He may have been doing some of that, too. Yet the complaint suggests that Madoff’s was mostly just the biggest, fattest one-player Ponzi scheme of all time.

Lesson?  Unless you’re a governor sitting on a U.S. Senate appointment, there is no free lunch.  No matter how “savvy” your broker or investment advisor, if he or she promises stratospheric returns, know that they come with stratospheric risk.  Risk and return run together.  When returns go up, so do the risks.  Returns on cocaine distribution are outrageous, but so are the risks.  Don’t invest unless you understand the source and nature of the risk.

In the Madoff case, it appears that Madoff’s investors trusted Madoff so completely that they figured they were exempt from responsible risk analysis and from demanding real internal controls over the fund.  Rule of thumb: In the world of finance and politics, those who are trusted the most are the most dangerous.

Savvy investors should demand rigorous internal controls, including a division of responsibilities among fund managers such that at least two pairs of eyes monitor all of the essential moving parts of the deal. The complaint excerpt shown below highlights the problem.  It suggests that no one but Madoff ever saw the books of his investment advisory scheme.  Don’t let it happen to you!

Investors could have saved themselves (and Madoff) by insisting on a process in which Madoff shared custody of the books, including bank and other financial account statements, with someone else, preferably someone independent of Madoff.  It’s a mystery why they did not do this.  Perhaps it was that they just didn’t want to know how he was actually generating those returns.