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Ponzi Schemes Explode

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In an article published in mid-December on the Bernard Madoff fraud, I wrote that we would witness multiple instances of Ponzi schemes coming undone over the next 18 months. Little did I know that it would be a matter of weeks, not months:

  • Today, authorities charged Nicholas Cosmo with operating a Ponzi scheme that bilked 1,500 investors out of more than $370 million.
  • Last Wednesday, federal authorities charged Florida money manager Arthur Nadel with fraud, alleging he overstated the value of investments in six funds by $300 million [although, technically, this isn't considered a Ponzi scheme]. Nadel was missing, but was arrested Tuesday.
  • The CFTC, which regulates U.S. futures markets, has already brought two cases of Ponzi schemes so far this year -- the largest of which involves a $50 million scheme orchestrated by Pennsylvania resident Joseph Forte. Last year, the CFTC brought a total of 15 cases.

A $370 million petty theft?
Under ordinary circumstances, the Cosmo and Nadel cases would be major news, but Madoff's $50 billion fraud has relegated these high-flying embezzlers to petty thief status.

Still, why are all these frauds coming to light simultaneously? A flight to cash.

In the present environment, cash is king -- and that holds at every level. Just as Bank of America (NYSE: BAC  ) and Royal Bank of Scotland (NYSE: RBS  ) have sold stakes in Chinese banks to boost their capital levels, individuals are also raising cash. As investors demand withdrawals simultaneously, this causes a Ponzi scheme to collapse, as the scheme operator cannot raise enough money from new investors to meet the redemptions of exiting investors.

Interestingly, it appears that large U.S. financial institutions sidestepped the Madoff land mine, while major European and Asian institutions were walking blind. Goldman Sachs (NYSE: GS  ) and Merrill Lynch (now part of Bank of America) declined to recommend Madoff after having looked at his operation.

UBS (NYSE: UBS  ) did the same, but still faces significant liabilities as a custodian for some of the infamous Madoff "feeder" funds. Meanwhile, HSBC (NYSE: HBC  ) faces up to $1 billion in losses on loans to feeder funds.

Buffett a Ponzi scheme operator?
How can you tell the difference between a Bernard Madoff and a Warren Buffett, the CEO of Berkshire Hathaway (NYSE: BRK-A  ) , (NYSE: BRK-B  ) and arguably the greatest investor in the world? When Buffett began managing investment partnerships as a young man in Omaha, some people thought he was operating a Ponzi scheme. The idea seems bizarre now, but it was much less absurd back then.

After all, Buffett worked alone, he was secretive and he handled the administrative paperwork of the partnerships himself. He generated market-beating returns consistently, but only reported his performance to his partners once a year. By 1960, Buffett was no longer marketing his partnerships – prospective partners had to ask to invest with him (this exclusivity was also part of Madoff's mystique).

In my follow-up article, "How to Tell Madoff from Buffett," I'll outline some of the key questions that investors need to ask in order to avoid financial fraud.

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Alex Dumortier, CFA has no beneficial interest in any of the other companies mentioned in this article. Berkshire Hathaway is a Motley Fool Inside Value recommendation and a Stock Advisor selection. The Fool owns shares of Berkshire Hathaway. Bank of America is a former Income Investor pick. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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