Crime in economics: Ponzi schemes
Author: Jelle Veldman
May 08, 2020
One of the well known crimes in economics is explained below. Read here how one trick became worth $65 billion dollars!
In tumultuous times like these, markets are unpredictable and signals point in various directions. The Split-Strike strategy appears to be an effective way to tackle this challenge. The major investment of the Split-Strike strategy is creating a portfolio that represents a major index, like for example the NASDAQ. It takes 25 to 30 different stocks of that index to achieve this, high dividend stocks being preferred. The next step would be to sell contracts so that in case the index goes up you can buy for the old price and sell them for the new value. These contracts are called call options. The possibility of the increase of the index is covered. To make a decrease profitable as well, you should buy put options at the current index value or at least as close as possible. If the index falls, you can still sell your stocks for the old price and thus losses are limited. Both directions of the market are covered and in case the market moves horizontally, you still earn from the dividends. Sounds good right? The strategy above is what Bernard “Bernie” Madoff sold in his $65 billion Ponzi Scheme.
Bernie Madoff was a former market maker who created an investment fund that sold the Split-Strike strategy but turned out to be one of the largest Ponzi schemes in history. At a certain point, Madoff’s fund would have had to trade more options than there were actually available in the markets. The scheme survived around 25 years to grow this big. It originated in the early 1980s and collapsed during the financial crisis in 2008. How could Bernie keep this scheme up for that long?
It was partly possible because of the architecture of the Ponzi scheme. In essence, a Ponzi scheme is similar to a pyramid game where new investors indirectly pay the interest payments to old investors. It works as follows: A starts a Ponzi scheme and promises interest payments of 50% a month. B and C invest €1000 in the scheme so that A has €2000. The first month A has to pay B and C their interest and thus will pay out €1000 in total. If he convinces them not to take out their money, he still has €1000 left, if not, he loses €1000. It’s therefore key in a Ponzi scheme to keep as many investments in the scheme as possible. B and C are in any case grateful for their high interest rates and tell others about their investment. D, E, F, G and H invest €1000 as well. A has now €6000, but has to pay €6500 in dividends. New investors pay for this and bring in extra money for A. This scheme goes on until the flow of new clients dies out. This is the essence of what Madoff did, but on a completely different scale. How did he get this scheme to get this big?
Madoff started as a market maker. Market makers continuously bid and ask prices and make money by the ‘spread’ between the actual price and the ask or bid price. To compete with other market makers, his market maker company started to use computer information technology to make the bid and ask prices. This later resulted in the development of the NASDAQ, making Madoff a respected businessman. He would even be the non-executive of the NASDAQ for several years. A Ponzi scheme needs a convincing story and a trustworthy seeming owner to make the flow of investors grow and to keep the investors from taking out their investments from the scheme. Madoff ticked both the boxes. He started his scheme with his family and friends, but later started developing friendly connections with wealthy and influential businessmen in New York and Palm Beach. After a couple of years, the dimensions of his scheme expanded even more when hedge funds and banks started to take care of the flow of investors. These institutions invested their clients' money in Madoff’s company, taking a percentage of the profit themselves and didn’t ask further questions. The only thing Madoff had to do was keeping his investors updated about the payouts and cash flows, which he made up.
Already in the 1990s there were fraud investigations, but when the traces lead to Madoff, no further questions were asked. Why would the head of the NASDAQ commit a Ponzi fraud? Some investigators were not satisfied and noticed that for Madoff’s strategy to work, he had to trade more options than there were actually available. Furthermore, during the 2008s crisis, which was marked by a general downfall of stocks, Madoff still recorded a result of 5.6%. Several reports from e.g. Markopolos and the SEC (Securities and Exchange Commission), combined with the crisis from 2008, led investors to cash out the money that was put in Madoff’s investment fund. Madoff confessed to his sons who eventually turned him in. Madoff was proven guilty of fraud and was sentenced to 150 years of prison. In February 2020 he requested an earlier release from prison due to severe health problems. From that date on, the former businessman did just one-fifteenth of his time in prison.