In this assignment we will explain in detail the characteristics that led one of the world's largest financial institutions to grow and evolve using a Ponzi scheme. By using extended information from different sources we will be able to understand how Madoff's Ponzi scam worked and operated for more than a decade with official regulatory authorities being kept in the dark. Furthermore we will briefly discuss the impact of Madoff's scheme into the financial world. We will go beyond the journalistic approach by analyzing reports given to the SEC by individual investigators proving from the beginning that Madoff's numbers and strategy were impossible to succeed without using illegal techniques.
Finally we will investigate the current regulation on financial institutions like "Madoff Investment Securities" and attempt to find measures or actions which could have been taken by the official regulation authorities in order to prevent similar schemes in the future.
Bernard Madoff began his operations in 1960 by creating a firm which was involved in market-making via the National Quotation Bureau's Pink sheets. With the help of his father in law accountant Saul Alpem he was able to compete with firms that were members of the New York Stock Exchange, while by introducing new technology into his firm he was able to become the largest buying and selling market-maker in NASDAQ.
His small firm, Bernard L. Madoff Investment Securities, got its start by matching buyers of inexpensive "penny stocks" with sellers in the growing over-the-counter market. In 1989 Madoff's firm was handling more than 5 percent of the trading volume on the New York Stock Exchange. The early success of his firm was due to his technique of offering to pay clients a penny or two for every share they traded, his firm would make money by pocketing the difference in the "spread," or the gap between the offering and selling price for the stocks.
Before creating one of the largest Ponzi scheme the world has ever seen Bernard Madoff was a pretty wealthy and successful brokerage-house chief. He was active in the national association of securities dealers and his firm was one of the five main developers of the NASDAQ, while he had also served as the Chairman of the Board of Directors of the NASD. His positions granted him credibility while he secured a longstanding role as an elder statesman on Wall Street, allowing him to land on important boards and commissions where his opinions helped shape securities regulations.
With the help received by his experience in securities regulations Bernard Madoff created the longer, wider and cut deeper Ponzi scheme the financial world had ever experienced. A Ponzi scam is usually simple in method. It is a fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any actual profit earned using complicated investment strategies. These kinds of schemes usually offer abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going. The system is destined to collapse because the earnings, if any, are less than the payments. Usually, as the number of investors increases the scheme is interrupted by legal authorities before it collapses, because a Ponzi scheme is suspected or because the promoter is ivolved in other illegal financial activities.
Bernard Madoff's scheme was typical of a Ponzi scheme in its structure, but differed in its pace and marketing. Rather than offering suspiciously high returns to all comers like most Ponzi schemes, Madoff offered modest, but steady returns to an exclusive client, produced in both up and down markets. Although his investment method was marketed as a "too complicated for outsiders to understand" the combination of stock purchases tracking some index and related puts and calls was his so called "secretly successful technique". While the true secret to Madoff's success was his lifetime involvement with non-profit charities, and the tax law knowledge he gleaned from that experience over many decades.
Initially charitable foundations were the basis, as well as the side-victims, of his surreptitious strategy. He exploited his own social networks, and over time, received implicit entry into new venues to promote himself and his company among his clients. He invested their significant funds consisting of educational foundations and social charities, as directed by them. By giving forged receipts of transactions made up by his sons brokerage firm he proved he was investing and by showing only "good months" he was able to avoid detection as well as mislead the accountants of his investors. The slow pace and ongoing cliquish "insider" word-of-mouth marketing enabled the deception to survive for several decades. It grew beyond the expectations of a common Ponzi scheme. Soon he and his promoters set their sights on Europe in order to attract bigger trades and more investments, once more framing the investment as membership in a select club which only selected member had the opportunity to reap the steady, solid returns Bernard Madoff's firm was promising. Unfortunately charity funds and large investors were not the only ones damaged by Madoff's operations. Many common investors were unknowingly investing in Madoff's hedge fund through their own funds. More than half of the $25 billion-plus in losses investors have so far claimed came to Madoff through so-called feeder funds. These funds were set up by outside firms, which would then funnel the money they received from investors to Madoff's hedge fund. Due to the secrecy and "exclusivity" of being one of his investors even the well known accounting firms acting as auditors and representing the funds investing in his hedge fund were kept in the dark unable to unveil his scam. Those large accounting firms could not be held liable like in any other hedge fund fraud because none of them were actually listed as auditing Bernard's Madoff hedge fund. Madoff's firm was using a small accounting audit firm in New York called Friehling & Horowitz which enabled him to hide the looses and only report the unusually high and consistent returns.
This giant Ponzi scheme was first noticed during 2000 in an attempt by Madoff's competitors to duplicate the high and solid returns in their investments. They hired Harry Markopoulos a securities executive officer in order to understand the complicated techniques Bernard Madoff was using for so long. Markopoulos tried again and again using quantitative math to duplicate his strategy but he could not simulate Madoff's returns, using information he had gathered about Madoff's trades in stocks and options. Markopoulos eventually decided Madoff was either running a Ponzi scheme - using money from new clients to pay off old ones or he was engaging in illegal "front running" which means stocks, improperly trading in investors' private accounts ahead of orders the firm received from outside clients. Even after leaving the job of a securities executive officer and becoming an independent financial fraud investigator Markopoulos was determined to unveil Madoff's scam. In 2005 he submitted to the Securities and Exchange Commission regulators a 21 page report called "The world's largest hedge fund is a scam" mathematically proving that Madoff's investments could not be earning so high and steady returns for over a decade. In his report Markopoulos outlines 29 red flags to the SEC and provides evidence to support his theories.
Since we have explained how Madoff's hedge fund operated we can understand some of the main points in Markopoulos report. By Markopoulos memo the SEC was informed in some of the actions taken by Madoff's firm in order to operate under the regulators radars. Madoff achieved these actions by funding his operations at a high implied interest rate even when cheaper money was available in the short term credit market.
By calculating in some extent the size of Madoff's hedge fund (20$-50$ billions) Markopoulos comments on the secrecy measures taken in order for the firm's size to stay hidden even from people investing on the firm, while other similar giant investment funds brag about the number of their financial assets.
Furthermore another interesting point in Markopoulos report which should have motivated the SEC and other regulatory authorities to take more immediate action was that Madoff's firm did not allow any outside performance audits and only accounting firms owned by member of his family were allowed to evaluate the company's performance for reasons of secrecy in order to keep Madoff's so called hypothetical strategy a secret to competitors.
Other points which should of been noticed by the SEC is the fact that Madoff's firm had only reported 7 months of small losses over the past 14,5 years. This point should have alerted the SEC that the receipts of trade presented by the company were created in order to represent stability.
Bernard Madoff's scheme showed the need for an overhaul of the patchwork system governing regulation of the financial markets. The SEC and other regulatory authorities were put on the defensive concerning their failure to uncover the more than a decade-long, multibillion-dollar fraud scheme. Some of the arguments of the SEC were the underfunding status of the commission as well as the bad co-operation with FINRA the industry regulator for investigating the brokerage operation. The agency needs to improve its internal processes for pursuing cases while also needs authority to regulate parts of the financial system that escape oversight and more funding to carry out more investigations.
Moreover arguments that the SEC should not be regulating private partnerships will be silenced since the co-operation of Madoff's hedge fund with his sons Broker-dealer firm and the accounting company involved in the scheme proved the need for an increase in hedge fund regulation. This will lead to expanded powers and increased funding for the SEC. For further investigation the SEC will hire 100 new enforcement staff members and move its inspections office from Washington headquarters to Wall Street in order to become more proactive and less reactive. The new regulators will report to the committee every three months on progress they were making in improving their processes for detecting fraud.
Finally the exact scale of Bernard Madoff's Ponzi scheme may never be known, but it probably runs to tens of billions of dollars. Madoff snookered thousands of the wealthiest people in America, dozens of charities and several universities as well as investors from Europe, especially France and Switzerland. His plan created thousands of victims, who lost money investing with him and have been identified as ordinary people, big hedge funds, charities, and well know international banks. The only comforting news arising from Madoff's giant Ponzi scheme is the fact that from now on hedge fund will face increased due diligence from regulators, investor, prime brokers, and counter parties in an attempt to avoid similar scams in the future.
