The Bernie Madoff Scandal Explained
Celebrities and households decimated. $60 billion gone. This is the Bernie Madoff Scandal explained from start to finish.
At one point, Bernie Madoff was one of the most respected men on Wall Street. As owner of one of the most successful investment firms in America and as the former chairman of NASDAQ, Madoff had the world at his feet. Everyone in the finance world wanted to be him.
Seemingly overnight, it all changed.
Families were devastated, entire retirement funds were gone, and the entire financial world became a massive whirlwind of chaos. The total amount of damage and lost funds exceeded $60 billion dollars. It was a story of white collar crime run amok.
To date, it is the largest private Ponzi scheme in history, and remains one of the most harrowing tales of investment fraud known to man. But, how did the Bernie Madoff scandal all happen?
Wall Street runs people through the crucible, and no one knew this better than Bernie Madoff. That's part of the reason why this scandal was so large; he had to prove himself trustworthy to get a Ponzi scheme that large going.
When he first hit the street in 1960, he started Bernard L. Madoff Investment Securities using $5,000 he earned from being a lifeguard. He quickly saw his firm grow.
He quickly acclimated to the math-centric life of a trader, and became one of the first traders to use computers to make markets and disseminate quotes. His innovative approach earned him a huge amount of respect among traders.
Later on, the tech he helped develop became used to create the NASDAQ index. He became a chairman of NASDAQ, and was seen as a major authority in the world of Wall Street.
By 1980, Madoff Securities traded around 5 percent of the total volume of the NYSE thanks to his inclusion of payment order flow. By 2000, Madoff Securities held around $300 million in assets.
Ponzi schemes are frauds that work by getting initial investors by offering guaranteed returns. Once they would invest money into the scheme, the schemer goes to find more recruits. They then use the money from the new investors to pay the old investors, all while skimming money off the transaction.
With this scandal, what ended up happening was that he created a "hedge fund" that guaranteed consistently good returns of 10 percent despite market fluctuations.
To allay investor fears, Madoff marketed the fund's strategy as a legitimate split-strike conversion. Yet, he never really explained any of the secrets of the fund to outsiders. The fund was marketed as "too complicated for outsiders to understand."
In reality, it was just a massive personal bank account Madoff owned. When people wanted to pull out money, he'd simply dip in and give them their returns as he calculated them.
To keep investors interested and paying in, he'd tell his clients how much they were theoretically making—even though they weren't really making anything at all.
Investors had every reason to trust him.
It's scary how much care Madoff put into cultivating his image in the public eye—and to be fair, most of the Bernard L. Madoff Securities company was run legitimately.
For decades, people who asked Madoff to trade securities for them never had an issue.
At one point, Bernie Madoff had become a member of National Association of Securities Dealers (NASD). NASD is a self-regulating board dedicated to providing excellent service and holding securities dealers accountable for their actions.
Additionally, the 10 percent annual average seemed very realistic. The best S&P 500 index funds have similar returns. Heck, there are many investments that provide a 10 percent annual return.
Madoff was a natural salesman who knew how to run a Ponzi scheme. To keep SEC eyes away from his doings, he kept the "fund" opportunity private. He very rarely met with investors in person, giving him a very "Wizard of Oz" type appeal.
He also actively would go after targets that had something in common with him, knowing that would spark trust in him. Whether it was a common religion, hometown, or industry, Madoff would approach victims and act like he was one of the guys.
Madoff also added a certain element of exclusivity to his hedge fund. So, you would have to be extraordinarily wealthy to even invest in the scam at all. By simple associations, people immediately assumed it was safe to trust Madoff.
Unfortunately, all investments have risk attached to them. Part of the reason investing like Warren Buffett is difficult is because you need to perform due diligence and understand what you're investing in.
Bernie Madoff's secrecy should have immediately prompted red flags. Why couldn't investors know the stocks used in the hedge fund? Why was it "too complex" for people to understand? Sadly, hindsight is 20/20.
There were certain signs that something wasn't all right with Bernie's organization. For example, Bernie was one of the largest companies to use payment of order flow to give stockbrokers reason to use their firm to work securities.
This practice was often called a "legal kickback," with many watchdogs calling out Madoff for its use. That being said, its ethics weren't necessarily the issue that raised peoples' eyebrows.
Madoff's employees saw more, especially when it came to the mysterious back office on the 17th floor of the Lipstick building he owned. Only a handful of people were given access to it—including a man named Frank DiPascali, who had only a high school education.
It also struck people as odd that Madoff had an IBM from the 1980s that he refused to let go of. Why would a man need a 20-year-old computer, when he could easily have bought a new one and uploaded the data?
Perhaps the most shocking sign for employees was seeing Bernie's bizarre change in behavior by the beginning of 2007. For much of his life, Bernie Madoff was known for being calm, pleasant, and constantly well-mannered.
On the stock market televisions, a wealthy hedge fund manager was found dead of suicide after leading a double life. When someone asked Madoff if he knew of the man, Madoff exploded and unleashed a tirade complete with profanities.
"I never saw him react like that before. It obviously hit a nerve." — An anonymous trader who witnessed the event.
Oddly enough, he was investigated multiple times before the scam came to light.
Prior to the Bernie Madoff scandal, Madoff Securities saw themselves the subject of eight different SEC investigations. Through loopholes and other similar workings, all those investigations failed to peg Madoff's Ponzi scheme.
One of the investigations geared towards a Madoff feeder fund, Avellino & Bienes, became the subject of investigation for selling unlicensed securities. They capitulated, paid a fine, and then continued their business.
Avellino & Bienes got some notoriety due to the investigation and client accounts boomed. The sheer amount of money being funneled to Madoff was staggering—and honestly a cause for concern for the SEC.
"We went into this thinking it could be a major catastrophe. They took in nearly a half a billion dollars in investor money, totally outside the system that we can monitor and regulate. That's pretty frightening." — Richard Walker, SEC's New York Regional Administrator
Avellino & Bienes, though, made no qualms about investing with Madoff. Michael Bienes actually didn't know that he was working with a scam artist, since he himself deposited money into Madoff's fund until the full scale of the scandal came to light.
When asked whether he doubted Bernie Madoff, this was what CEO Michael Bienes had to say:
"Doubt Bernie Madoff? Doubt Bernie? No. You doubt God. You can doubt God, but you don't doubt Bernie. He had that aura about him."
Harry Marcopolos, a rival hedge fund manager, regularly tried to expose Bernie Madoff's scheme. However, no one believed him despite the proof he furnished.
The problem with Ponzi schemes is that they aren't really sustainable.
Ponzi schemes fall apart whenever there aren't enough investors to keep the flow going, or whenever the schemer decides to bail. During the financial crises that sparked the Great Recession of 2006, people began to request money from Madoff's fund.
Around $7 billion was to be removed from the hedge fund. At the time, Bernie's account only had around $300 million left, leaving the entire scheme on the verge of collapse.
Bernie Madoff was well-aware he was going to be done for good. So, he urged his sons to pay out $170 million in bonuses to the firm's employees, despite the company not having enough money to pay out investors.
His sons knew they had to pay out billions in cash, but didn't have the money to make it happen. So, they asked him what happened.
He confessed the scheme to his sons, Andrew and Mark, that the fund was a "big lie." The brothers immediately reported their father to the FBI.
A massive investigation ensued. Almost every family member he had was employed at the firm, meaning that the entire family was dragged into the investigation. What investigators found dropped jaws, and quickly became labeled as the Bernie Madoff scandal.
Bernie Madoff pled guilty to all charges brought forth by the FBI, which led him to serve a maximum sentence of 150 years in prison. Dozens of co-conspirators, including Madoff's lawyers, were also charged and sentenced in the process.
The hardest part of getting justice for scandal victims was trying to recover the lost funds. So far, only a fraction of the lost funds were recovered—with around $8 billion confirmed so far.
Harry Marcopolos was proven correct. Congress gave the SEC a serious tongue-lashing, and created a new whistleblower program to help people in Marcopolos' situation.
It was obvious that the scam victims were deeply impacted, with many becoming penniless overnight. Steven Spielberg, Elie Wiesel, and Leonard Feinstein were just some of the famous victims of the scam. Yet, they were not the only victims by any means of the word.
Almost all of the employees at Madoff Securities have found themselves blacklisted from finance, even if they weren't charged. Many remain unemployed despite the economy coming back to life, total pariahs in the field they once adored.
Bernie Madoff's family didn't remain unscathed either.
Madoff's son, Mark, killed himself exactly two years after the Madoff scandal broke out. Family members claimed that he was anxious and bitter about his father's crime. Bernie's other son, Andrew, died at 48 of cancer.
Andrew and Mark's wives have also lived without the luxuries they once took for granted. Neither of them has been able to shake the "Madoff" notoriety in the least bit.
Ruth Madoff, his wife, has become a pariah in the world she once enjoyed and keeps to herself. Unlike the life she lived with her husband, her current lifestyle is very modest and very quiet. She still deals with harassment on a regular basis.
“No father should do that to their sons.” — Andrew Madoff