Avoiding the Next $50 Billion Ponzi Scheme

At the end of last week, news broke that Bernard Madoff, a former chairman of the Nasdaq -- now Nasdaq OMX Group (Nasdaq: NDAQ  ) -- had been heading up a $50 billion Ponzi scheme. This scandal raises numerous uncomfortable questions for regulators and professional investors who were burned. However, even though we could end up looking at the largest Ponzi scheme ever perpetrated, I can assure you that this is only the tip of the iceberg.

There will be others
We'll see several fraudulent schemes coming undone over the next 18 months. Why? Because things cannot turn out differently. Financial bubbles are always accompanied by a multiplication of frauds, and we are now unwinding one of the largest bubbles in history. In the run-up of a bubble, greed and uncontrolled enthusiasm snuff out skepticism and prudence. Such an environment is ideal for confidence men (and women) to ply their trade.

Due diligence for dummies
In this case, however, the number and prominence of the red flags is startling: silky-smooth returns over long time periods, a willingness to forsake hundreds of millions of dollars in performance fees to avoid the hassle of administering hedge funds, fund accounting provided by a "hole-in-the-wall" accounting firm -- it's all there. Descriptions of Madoff's operation read like a cheat sheet out of Investment Fund Due Diligence for Dummies.

This isn't a case in which hindsight is 20/20, either. Members of the finance community were pointing out all of these elements long before the fraud was revealed. In 1999, a finance professional named Harry Markopolos wrote in a letter to the SEC that "Madoff Securities is the world's largest Ponzi scheme." He took the words right out of Madoff's mouth!

Collateral damage
Madoff's fraud is a further blow to the financial sector's reputation. Thankfully, however, I have seen no reports that prominent U.S. companies such as Goldman Sachs (NYSE: GS  ) , Morgan Stanley (NYSE: MS  ) , JPMorgan Chase (NYSE: JPM  ) , Citigroup (NYSE: C  ) or Bank of America (NYSE: BAC  ) have any exposure to it -- contrary to major international institutions including HSBC (NYSE: HBC  ) , Nomura, BNP Paribas, and Grupo Santander.

Nevertheless, numerous groups will need to give an accounting of how they came to invest with Madoff to their clients and shareholders. For everyone else, the SEC owes a public explanation of how a blatant fraud of this magnitude was able to continue unhindered for so long.

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Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor picks. Nasdaq OMX Group is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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  • Report this Comment On December 15, 2008, at 7:04 PM, RANSOMsPOINT wrote:

    It's the old advise of "buyers beware"! Trust no one! Develop your own wisdom and knowledge. Understand what you are buying. Even the smartest and best brains in the business can stick-it-to-you! Like it is said, we haven't seen the end yet, it's only the tip of the iceberg!

  • Report this Comment On December 15, 2008, at 7:41 PM, hsvhughes wrote:

    Classical investors did not cause the current stock market turmoil. Traders, speculators, and dishonest "managers" selling risky derivatives dressed up in AAA costume to did it all on their own. The typical 401K investor, like me, has a full-time job and does not have time to "play the market". Capitalism is getting a bad name around the world because of greedy crooks wanting money for noth'n and chicks for free. We need a remedy that none of the "players" want. For just a moment, take off your "player" hat and think logically about what got us in this mess, and you will realize what must be done. Think about what the stock market was originally set up for and you will get a clue.

  • Report this Comment On December 15, 2008, at 7:52 PM, GandhiSingapore wrote:

    How could this also go unnoticed by the external auditors of the companies/funds in question? There must be a "hole" or several holes (!) somewhere. Looking forward to hearing what the SEC explanation is for not spotting. Wonder how long have the fraudulent activities been going on?

  • Report this Comment On December 15, 2008, at 8:06 PM, Inn2orbit wrote:

    well....I assume it is not disrespectful to state that it gets a bit old to be constantly lured by your emails that lead one to think you are giving some advice , as you state, 'it is free"...and after clicking to discover it is one more of constant pitches to a so-called free trial which is actually a commitment to purchase, but with a 30 day refund guarantee; I originally purchased and am happy with my Stock Advisor newsletter, but did not expect this constant bombardment to keep buy more and more products...not to mention that if market situations call for new information to your clients, why is it not put into my Stock Advisor that I am paying for? I must say that though I am reasonably happy with SA, this practice leaves me feeling like my newsletter is not comprehensive enough to warrant the annual cost (other newsletters, at similar prices, have more in depth new suggestions than I am experiencing with motley fool stock advisor.

    Best Regards ,

    Jim D

  • Report this Comment On December 15, 2008, at 8:21 PM, witter1217 wrote:

    I want to agree with the comments of Jim D. All of your free advise ends up asking for a fee to continue.

    Bill W.

  • Report this Comment On December 15, 2008, at 8:47 PM, InvestigatorBo wrote:

    I am fifty seven and did not have much exposure to the stock market until four years ago when a public company bought out a business where I had an interest. In a cash and stock deal I was forced to learn about the market and I can only say continued revelations of crooks and huckster CEO's who sound more like Sunday morning used car salesman leave me wanting to take a shower after watching financial news. My eighty year old father who grew up in the depression simply refers to it as "The funny farm". The bottom line is when you try to make money without any true labor you may actually deserved to be swindled.

  • Report this Comment On December 16, 2008, at 3:13 AM, Starzz43 wrote:

    Well I saw this failure on Wall Street today of Madoff..... and how many people investing millions and some of them loosing all they owned.. Sad..

    But I was sitting here thinking about my dad and how he invested as he grew up with.. absolutely nothing.. riding in a horse drawn wagon... moving from place to place as a child with his brother and sister and mom and dad..... and I think about that.... cold nights, cold houses, hot summer nights.. but they managed.......... my dad even canned vegetables to take to college with him..during that depression time....... but he graduated and his work made changes that affect almost everyone on the planet today... he changed the way wheat was harvested and he changed the way peanuts were also... he was an agricultural engineer .. he designed equipment to harvest crops.. and thus made changes to wheat and peanuts harvesting equipment.

    He even went so far as to contacting a Congressman with his ideas and it resulted in a large Peanut Lab being established in Dawson, Ga. .

    My dad put everything into Treasury stuff as he didn't trust anyone except the government at that time.. but I wanted to venture..

    But his way of investing was when I wanted my first stock..at age 18 and they gave me money to invest... and I didn't know what to put the money in.. just knew I wanted some stock.. and my dad said on the way to Merrill Lynch to open an account and to buy something .. that everyone (now this was in the 60's) always went to the Coca Cola machine at break time for a 5 cent Coke... so that day I bought 3 shares of Coca Cola at about $100. at that time.. but today I have over 300 shares from that first 3 shares and never bought another share..

    But his thoughts were (like that Coke machine) what people should think about now in tight times on Wall Street......... well we do need a home to live in.. but after that what do we need..... Lets go back to the basics on Wall Street and build it back up from the bottom with fundamentals........ Yes we need banks and investment firms and Vegas etc. but first lets start with our basic needs at home..

    We all need our house and food.. we need heat and some of us need cooling (but this one is not necessary yet) .. We need transportation locally like a car or vehicle.. and we need fuel for that vehicle.. then the list goes on .. go back to the core companies and start buying there .. then venture out more.. but once these basics are met and we have extra money it can be spent for luxury items over the basic necessities..

    Just think about how many businesses have been started just over trying to improve or add a novelty to something that we have as a basic.. and I just thought about hub caps or wheels on cars and how much this industry has made in money over the years.. !! I am sure that you have your own ideas.. !!!

    But start at the basics (or bottom) and then move cautiously upward.. The basics should always make some money..

    Just my thoughts,

    George

  • Report this Comment On December 16, 2008, at 9:23 AM, williambanzai7 wrote:

    PALM BEACH GOT RUN OVER BY MADOFF'S PONZI REINDEER

    (Grandma Got Run Over By a Reindeer)

    WilliamBanzai7

    (chorus)

    Palm Beach got run over by Bernie Madoff's Ponzi reindeer

    Just two weeks before Christmas Eve

    You can say there's no such thing as a Wall Street scamster

    But as for we in America, we believe

    He'd been chalking up bogus Alpha

    So the SEC said he had to go

    And as he waltzed out of his lair on Third Avenue

    Defiant as he was, he said, "Positive returns, hell no!"

    When they woke up yesterday morning

    It was clear the Palm Beach clique had been attacked

    May as well stick a note to their own foreheads

    Saying, "Oh Lord, please give us our money back!!"

    (repeat chorus)

    Now we're all so proud of our regulators

    They've been taking this so well

    See them crammed in Madoff's office

    Knowing that SEC Chairman Cox will soon be sent to pink slip h-e-l-l

    It won't be a Merry Christmas thanks to Madoff

    Nor a Happy Hannukah as well

    And we just can't help but wonder

    Dosn't all of Wall Street have that pungent Ponzi smell?

    (repeat chorus)

    Now that Madoff's books are on the table

    See all the other asset managers dance a jig (Ah!)

    And the bogus billion dollar earnings

    That not surprisingly had been rigged!

    Be forewarned all you rich country club investors

    Better watch out for yourselves!

    You should not be dreaming of serial Alpha

    With hedge fund goofs who play golf better than yourselves!

    (repeat chorus)

  • Report this Comment On December 16, 2008, at 11:56 AM, rfaramir wrote:

    "Madoff Securities is the world's largest Ponzi scheme."

    I'd correct that to the largest PRIVATE Ponzi scheme. Our Social Security is the biggest, unless another even more socialist country has a bigger one.

    The time to wind it down is now, while there is still more coming in than going out. Every penny not needed for current obligations ought to be used to privatize at least a portion of future retirees benefits. Up to now, every surplus penny has been spent (wasted) by Congress.

  • Report this Comment On December 16, 2008, at 12:31 PM, TMFAleph1 wrote:

    "I'd correct that to the largest PRIVATE Ponzi scheme. Our Social Security is the biggest, unless another even more socialist country has a bigger one."

    rfaramir,

    Well spotted; I have to agree with you on that.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On December 16, 2008, at 3:01 PM, MFMerlin wrote:

    So, let's see here, the SEC first became aware of this pending debacle back in 1999 and it takes them 10 years to shut it down, hmmmmm........ I know that if I performed this badly in my own business, I wouldn't have many clients left. I'm thinking this may be a case of the fox watching the hen house.

    No, Goldman Sachs, Citigroup et alia didn't have any exposure to this - why would they? They were too busy constructing their own version of it. Now, because the government tells us that these folks are 'to big to fail', the taxpayers are forced to become the 'final investors' in the banks version of a Ponzi scheme. Just in case someone wishes to point out what the banks did was 'legal', I might say that so is the 'scheme' the government calls Social Security.

  • Report this Comment On December 16, 2008, at 3:30 PM, sept2749 wrote:

    The "ole" Ponzi sceme again. I imagine when most people are getting good returns on their money they don't ask questions. However, all Ponzi like rip-offs will eventually fall apart and the crap will hit the fan as in this case. Frankly, I feel terrible for the many who lost everything. Can YOU imagine losing everything? I almost signed up with an investment advisory company the other day (nameless of course) but pulled back when I read some negative things on the net. Then when this Madoff thing hit the news I knew I was not being paranoid - just following my gut instinct which tells me: if it sounds too good to be true then it's too good to be true! I live by this now. I also am learning my own way around the market and love Motley fools inside value.

  • Report this Comment On December 17, 2008, at 10:41 PM, pauljfitzgerald wrote:

    Good returns on investments or not, something didn't smell right about the world of finance for the past few years. I kept thinking phrases like "house of cards" and "high rollers," "smoke and mirrors" and "sleight of hand." And that was from reading about the instruments that were respectable and legal, supposedly. So it's no surprise to me that it became easy to cross the line even for these so-called respectable high rollers.

    A few weeks ago, I got morning coffee in a McDonald's and heard the usual group of retired men grousing about the economy. One said, "The market's trading on fear, the market's not trading on value." Another added, "Plague of locusts." I thought that about summed up what was wrong. Then I read about the "mortgage sluts," former manicurists and such, who got into the frenzied world of subprime mortgages, traded sex for mortgages and falsified applicants'' credit information. I thought, well, we just went past Plague of Locusts directly to Sodom and Gomorrah.

    There needs to be a public demand for ethical and law-abiding behavior, and the government oversight to ensure that it happens. I hope people start to realize that demanding that everyone play by the rules doesn't make you a chump or a polyanna, it makes you a shrewd citizen.

    "If it seems too good to be true..." doesn't just apply to Ponzi schemes, it should apply to the whole economy.

  • Report this Comment On December 19, 2008, at 5:27 PM, slave2whitewater wrote:

    Did Bernie have his son turn him in to avoid the entire family from going to jail? What a fantastic parent. Was the Madoff family lip locked with the SEC?

  • Report this Comment On December 19, 2008, at 7:46 PM, poncho9191 wrote:

    Madoff is giving Ponzi a worse name. Maybe we should refer to subsecquent similiar ventures as "Madoff schemes" rather than poor old Ponzi schemes. Ponzi served time I doubt if Madoff will ever see the inside of a holding cell. Too rich, too well connected, and too old.

  • Report this Comment On April 15, 2009, at 5:45 AM, KameronH wrote:

    The giant scam hits many investments in the nation. The Ponzi Scheme investment fraud has affected many wealthy investors as well as charitable foundations because of Bernie Madoff’s hedge funds fraud. If Madoff hadn't faced $7 billion in redemptions, this Ponzi scheme might not have been discovered. What's astonishing is that he got away with it for so long with nobody discovering it. There is also Ezra Merkin who was recently added to the others sued in conjunction with the Madoff scandal. He is accused of having run the feeder funds that gave cash advances to Madoff. Madoff himself is awaiting sentencing, while his lawyers try to appeal his bail revocation. Merkin hasn't been charged with a crime yet, only sued. But there may be a need for some big cash advances so <a rev="vote for" title="Ezra Merkin Charged in Madoff Ponzi Scheme" href="http://personalmoneystore.com/moneyblog/2009/04/06/ezra-merk... Merkin</a> can pay his fines.

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