Sunday, December 14, 2008

The Perfect Ponzi

Henry Blodget in Clusterstock:

As the investigations into Bernie Madoff's gigantic Ponzi scheme continue, one thing is becoming clear: The reason it lasted so long and got so huge is that it was superbly executed.

In fact, if the global economic collapse had not prompted a mass of Madoff investors to demand their money all at once, it likely would have gone undetected until after Bernie's death (and possibly longer, if--as many people assume--his family was in on it.)

Here are many of the key factors that had people begging to be allowed to invest with Bernie and many of the world's smartest money minds doing what they have spent a lifetime telling other people not to do--take his returns on faith.

  • Nicest guy in the room. People genuinely like Bernie and regard him as a class actl. He and his family gave many people their starts on Wall Street, and based on some notes we received yesterday, they will never stop being grateful to him for that. Bernie's philanthropy and public service endeared him to institutions and the public. Except for the occasional prickly exchange with those asking for more detail on how he generated his returns, he seems to have been roundly beloved.
  • Never promised (or delivered) huge returns. No better way to earn trust than to seem more reasonable and realistic than the typical salesperson. If Bernie had posted huge fake returns for a few years to draw in new investors, he'd have been found out long ago. Bernie often urged new clients to start small: After a few years, as they got more comfortable, they could increase their investments. A crook obviously wouldn't do that!
  • Turned money away. Some people joined country clubs in the hope that Bernie would allow them to invest. And, in many cases, he wouldn't! It will be interesting to hear Bernie's motivation for turning people away. Did he just want to keep the number of investors small, or, at some level, was he warning some people away from the fraud?
  • Trusted representatives. Bernie himself didn't sell his services much. Instead, most of his clients appear to have been recruited by pillars of each respective community. These folks weren't paid (generally). They were doing favors for their friends. Bernie's services were also sold by entities such as Tremont Capital, Fairfield, Nomura, and other trusted institutions that were audited by real auditing firms: Who would suspect that these brilliant folks would allow themselves to be snookered by such a con?
  • Strategy with a simple name that was too complex for most people to understand. Bernie told everyone he used a "split-strike" strategy. 95% of his clients probably had no idea what that was, even he had actually been using it. But it sounded smart and conservative, especially when accompanied by a piece of paper showing dozens of months of remarkably consistent returns.
  • Returned money on demand. Building trust slowly and consistently is critical (and the failure to do this is the downfall of many schemes). And nothing builds trust faster than having a big check with big gains returned on demand.
  • Another potential explanation for the performance, which also involved cheating. This is important. As we noted yesterday, many sophisticated Wall Streeters have long suspected that Bernie was crooked. But they invested with him anyway because they assumed that what he was doing was "front running"--an illegal but simple and effective practice in which traders take advantage of the knowledge of impending order flows. The possibility that Bernie was front-running explained performance that no one could replicate and that some experts thought was impossible. This stopped a handful of folks who knew enough to know that Bernie was full of it from crying "foul."
  • Long-term greedy. Unlike most other Ponzi artists, who get busted after a couple of years, Bernie has enjoyed a lifetime of supreme wealth and reputation. This is in large part because he didn't try to shoot the moon. It takes a long time to build a track record that sells itself, and Bernie had the patience to do this. Based on everything else we've heard about him, we suspect this was in part because he hoped that, someday, his real returns would catch up to his fictitious returns, and it would all turn out okay.

We will now likely have a period of silence from Bernie and his family as the investigation and prosecution unfold. Assuming Bernie is as good a guy as everyone says, however, we hope that he can someday be persuaded to tell his story in full.

Our guess is that like that of many once-revered figures, Bernie did not set out to swindle anyone. In the beginning, he probably produced the returns he said he produced. Then, somewhere along the line, he probably had a bad month or two that he thought he could quickly offset with a strong one. So he fudged the results and then got back to even.

He probably did this a few times until, eventually, the recovery didn't get him back to even. Instead of admitting this, however, he kept it up in the hopes that someday it would--and in the hope that he would be able to preserve his life and reputation.

If Bernie really was "stressed" in the weeks leading up to the scheme's collapse, we suspect it was because he was finally realizing that the lie he had been telling himself for years--that someday he would trade his way back to legitimacy--was fiction. And that everything he had spent his entire life building was about to disappear--along with tens of billions of dollars of institutional money and the life-savings of hundreds of dupes who loved and trusted him and had come to regard him as a savior.

Calculated Risk also has a nice collection of stories on the scam.

1 comment:

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