The $50-billion BMIS debacle: How a Ponzi scheme works

It looks as if the smart money on Wall Street was pretty dumb.

They were the ones who invested with Bernard Madoff, who is alleged to have run a huge Ponzi scheme. It is said to be one of the biggest frauds in the history of Wall Street.

"Our complaint alleges a stunning fraud that appears to be of epic proportions," said Andrew Calamari, the associate director of enforcement at the New York office of the Securities and Exchange Commission, the watchdog for securities fraud in the U.S.

Last Thursday police arrested Madoff saying the scheme he ran on a separate floor of his New York office could end up costing investors as much as $50 billion US. Madoff is out on $10-million bail.

His lawyer says it's all a terrible misunderstanding. "Bernard Madoff is a longstanding leader in the financial services industry and we are co-operating fully with the government and regulators investigations into this unfortunate set of events."

But prosecutors say Madoff told the people who arrested him, "There is no innocent explanation."

The 24 pages of charges by the SEC say that, "Madoff admitted to one or more employees of BMIS [Bernard Madoff Investment Securities] that for many years he has been conducting a Ponzi-scheme through the investment adviser activities of BMIS and that BMIS has liabilities of approximately $50 billion."

Bernard Madoff

The man behind the alleged scam, 70-year-old Bernard Madoff, is described as having been a fixture on Wall Street for almost 50 years. He was once chairman of the board of the NASDAQ exchange. This is like a bishop being arrested and accused of stealing from the poor box.

Madoff and his wife were big-time philanthropists and split their time between a $5-million apartment on New York's Upper East Side and Palm Beach, Fla. Madoff was a member of the Palm Beach Country Club, where he found many of his new clients.

Some super-rich people are said to be potential victims of the fund run by Madoff. According to the Wall Street Journal, they include the chairman of GMAC (General Motors Acceptance Corporation), and the owners of the New York Mets and the Philadelphia Eagles. Hedge funds in the United States and banks in France, Switzerland and Japan were also said to be taken in.

"I'm wiped out," hedge fund manager Sandra Manzke told the Wall Street Journal. Her losses are estimated at $280 million.

The charges

The SEC charges say the operation was run on a separate floor of Bernard L Madoff Investment Securities, its  "cryptic" financial statements kept "under lock and key." 

According to the SEC charges, Madoff took in investors' money and said it was for investments that used options to guarantee a safe return. His investors reported he returned eight to 12 per cent a year, pretty spectacular in these markets. But Madoff never really earned the money, says the SEC — it's alleged he paid the first investors with money from the new investors, building up debt, not assets.

Many people just reinvested their money, so Madoff was alleged to be able to churn over the cash. The SEC charges say when investors short of cash asked for about $7 billion, the scheme fell apart.

Throughout its charges the SEC uses the term "Ponzi scheme," and even quotes Madoff as admitting last week: "It's all just one big lie … basically a giant Ponzi scheme."

So what exactly is a Ponzi scheme?

Well, it's a kind of pyramid sales scam, where the original investors are paid off by the new investors.  It is named after Charles Ponzi, who immigrated to the United States in 1903, moving to Montreal in 1907. He worked for a bank in Montreal, it failed, and then he forged cheques to make a living. He served a jail term in Quebec before moving back to Boston.

The scam that made Ponzi immortal started in early 1920. He offered depositors a 50 per cent return in 45 days. Within weeks money was pouring in. He paid off some early investors with money from the later investors. By July of 1920 Ponzi was making $250,000 a day.

Of course it couldn't last.  By November he was in jail, serving a five-year sentence. But Ponzi's name lives on to describe his type of fraud.

What is amazing about the alleged Ponzi scheme at Madoff Securities is how long it's said to have lasted.

"The cops can't catch every crook, but a sophisticated financial system should be able to spot a multibillion-dollar Ponzi scheme operating in its midst for years," said the Wall Street Journal.

Visit the firm's website and a short note tells you a law firm has  been appointed as "… receiver over the assets and accounts of Bernard L. Madoff Investment Securities LLC ("BMIS")."

The blunt message tells them to call a number with a Texas area code. Ring the number and a recording asks investors to be patient — but it looks like the end of the line for Madoff's unfortunate clients, who range from schoolteachers, with as little as $50,000 invested, to billionaires.

Fred Langan is host of Newsworld Business News.