Capital Budgeting and the Treatment of Inflation
Forecasts Spread Over a Period of Time Inflation is an ever persistent condition in today’s economy. The purchasing power of money has been reducing year after year for decades now. Apart from the occasional recession where money may gain real value, the usual case is a loss of value. Investors are investing money today. They […]
The Impact of Bankruptcy on Shareholders
Companies that file for bankruptcy also have a capital structure just like normal companies. This means that their capital structure is comprised of debt as well as equity. In the past few articles, we have been continuously talking about the interests of the debt holders i.e., how they will get paid in the event of […]
Why Unicorn Companies Fail?
Startup companies typically have a high failure rate. It is said that 90% of all startup companies fail. The percentage of companies failing keeps on reducing as the company grows and obtains more funding. Ideally, when a company becomes a unicorn i.e. achieves a valuation of $1 billion, then there shouldn’t be any chances of […]
Optimism Bias
The gist of optimism bias is often expressed by using the popular saying “rose-tinted glasses.” In real life, it is helpful to be an optimist. Optimists often live happier and healthier lives. However, when it comes to financial markets, a healthy dose of skepticism is not only necessary but also recommended by many experts. In […]
Hard Brexit vs. Soft Brexit
The British government has held a referendum wherein the majority of British citizens voted to leave the European Union. This phenomenon has been popularly named “Brexit” by the media. The fact that Britain will leave the European Union is certain. However, there is still a lot of uncertainty regarding the terms on which Britain will […]
The Bernie Madoff scandal was a story of a $50 billion embezzlement and Ponzi scheme run by Madoff Securities LLC. The scandal broke out in 2008 and sent shockwaves in the United States as well as across the world.
The world had seen many Ponzi schemes. However, this one was unique given the fact that it had been running for over two decades in one of the most regulated markets in the world. The existence of the Madoff scam made people question the existence and competence of regulatory bodies like Securities Exchange Commission (SEC).
The SEC was not able to detect this scam till the very end. It is only when Madoff’s two sons got wind of their father s illegal operations that they reported the issue to the authorities and Madoff was arrested. Madoff was later charged with financial fraud and embezzlement to which he pled guilty without trial and is today serving his 150 year sentence in prison.
Bernie Madoff had started as a small time penny stock broker in the 1960’s. His claim to fame was software that was developed by his brother that could supposedly pick profitable trades within a few seconds. A lot of people invested with Madoff and made good money giving his company a good reputation. Soon Madoff LLC grew into a financial powerhouse and was the sixth largest market maker on Wall Street. Madoff became a very well respected figure on Wall Street and served on the boards of various stock exchanges as well.
Madoff had three lines of business. Apart from brokerage, he also conducted proprietary trading. However, it was the hedge fund that was the crown jewel of his empire. This was personally managed by Bernie Madoff and was the epicenter of the gigantic $50 billion embezzlement, probably the largest in world history.
Bernie Madoff’s hedge fund was a class apart. While other hedge funds were looked upon as speculators, Madoff was looked upon as an expert money manager. Other funds had erratic returns. Sometimes they would make a lot of money and at other times they would lose a lot. This is a fundamental characteristic of hedge funds and the basic reason why only accredited investors with more than a $200000 net worth can invest in them. The average investor is kept away from hedge funds by the government because of the massive risks involved.
Bernie’s fund had been giving a consistent return of close to 12% for decades. The fund had seemingly survived many recessions and crashes. However, the record was impeccable and 12% return worked like clockwork.
People would queue up to give Bernie their money and Bernie was very selective about who he did business with. Getting Bernie Madoff to manage their money became a status symbol amongst the wealthy as Bernie’s selectiveness gave him an aura of exclusivity and created a high end brand.
Needless to say, the reality of the funds managed by Madoff’s hedge funds was very different than what the illusion was. Madoff had no magical way of navigating the ups and downs of the market and always creating a 12% return at the end of it. In reality, Madoff was paying off the old investors by receiving money from the new ones. This is the very definition of a Ponzi scheme i.e. financial fraud!
Madoff was very selective about his investors because he mostly managed money for large charities and non profits. These institutions were regulated by the law and had predictable withdrawal patterns. Hence, Madoff maintained a percentage between the money managed for non profits and the money managed for private individuals. This would enable him to make payments if demanded by the investors and thereby prevent a run on the fund!
Bernie Madoff’s trusted aides had set up an entire secret operation wherein they would always pay a 12% return on withdrawal or even in the annual statements. His accomplices would simply reverse engineer the trades and claim to have purchased and sold certain securities which in retrospect would make achieving this return appear very probable. An entire software unit was set up on the mysterious 17th floor of the office wherein these fabricated statements were created. Investors did not have online access to their accounts and as such could not check their statements real time.
Madoff was reported on several times before the 2008 fallout. In fact, one investor had given a 21 page letter to the Boston SEC enumerating reasons as to why Madoff Investments could not be a legitimate business operation. However, surprisingly a blind eye was turned towards such complaints which were regarded as vicious attempts by jilted competitors to malign Madoff’s name.
In retrospect, Madoff’s significant influence in Washington could have played a major part in getting him off the hook multiple times. Also, Madoff’s niece was married to a senior SEC official making SEC part of the family too! However, no charges of corruption have been proven and from the public version of the tale, it seems like Madoff was simply smart enough to fend off the regulators several times and continue the Ponzi empire till it became fundamentally unsustainable in 2008.
Madoff is said to have confessed the situation to his two sons who reported it immediately to the regulators since they did not want to be part of the scandal.
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