The Curious Case of Bernie Madoff
Updated: Jun 18, 2020
Meet Bernie Madoff. Once the non-executive chairman of NASDAQ, he was the man who had been consistent with his returns on investment throughout his career. Interestingly, if you wanted Madoff to invest for you and earn you some good money, you had to have someone he knew vouch for you. Well, would you be convinced to let such a man invest for you in the stock markets? The American investors were.
Things were going smooth for Madoff until came Harry Markopolos, who was a portfolio manager at Rampart investment firm in the '90s. He was instructed to replicate Madoff's investing strategy to earn consistent returns for his own firm. In the quest to be inspired by him, he instead discovered the biggest fraud in US history. While he was trying to reverse engineer Madoff's strategy, he realized that Madoff's returns had been far too consistent to be true. As a matter of fact, he was making profits on every investment, irrespective of the stock market direction. Madoff's returns were unaffected by market fluctuations. This was unreal.
This could have happened only in two cases—either insider trading or a Ponzi scheme. Insider trading is basically when one trades to one's own advantage with access to some confidential information that hasn't been disclosed to the market, and that piece of information is likely to affect the stock prices. This is illegal as it gives an investor an unfair advantage and allows the insider party to manipulate their company's stock value artificially.
Ponzi scheme is a simple concept. Under this scheme, a person doesn't actually invest in the market. He raises money from the group of investors and using that money, he pays the earlier batch of investors in the name of returns and keeps some for himself. There are no legitimate earnings. To keep the scheme working, you need a constant flow of money and the scheme would collapse, if existing investors cash out. A Ponzi scheme uses deception for financial gain.
Hold on! Now comes the most interesting part of the investigation. As per his speculations, Harry Markopolos found that Bernie Madoff hasn't made a single trade on the exchange for a very long time. Adding to it, for Madoff's strategy to work, he would have to abort more options on the Chicago Stock exchange than existed. If these were true, then where were the consistent returns coming from? Clearly, it was a Ponzi scheme.
Harry went to the SEC (five times) to report the fraud, but the political connections of Madoff and the manipulations saved the man. (SEC is the stock market regulatory body of America, precisely like SEBI of India).
Ironically, the financial crisis of 2008 bought Madoff's deeds into the limelight. In 2008, as Dow Jones was crashing, the investors were panicking. This meant that no new money would be pumped into Madoff's account for that period, and clients will ask back for their original investments. This marked the collapse of the Ponzi scheme. Madoff tried aggressively to raise loans with all kinds of tactics, but all his efforts went in vain. He knew that this was the end, and he surrendered himself.
This cost the U.S. economy 65 billion dollars. Crazy, right?
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