The Bernard Madoff Scandal: How Many More Ponzi Schemes Are There?

An important question arising from the Bernard Madoff scandal is what wider impact will it have? The proportions of the reported fraud--$50 billion over the course of years--probably set some sort of record. The victims included a number of people who could be featured in Lifestyles of the Rich and Famous. The fact that some charities--and, consequently, the beneficiaries of their charitable activities--were also victims darkens the tragedy of the events.

This is the sort of event that shakes investor confidence--in this case, the investors who have enough to turn it over to money managers. These aren't the people with $50,000 or $100,000 in a mutual fund; or $200,000 in a stock trading account. These are people with millions, who hand their hard-earned assets over to investment professionals that supposedly can provide them with selective access to especially good investments. Many of these investors have tony addresses in West Palm Beach, the Hamptons, La Jolla and Marin County. But others live relatively modestly in suburbs better known for the quality of their schools than the opulence of their neighborhoods. These folks tend to be highly skilled in their chosen fields or professions, but not terribly sophisticated about money. That's why they rely on money managers.

When it's reported that a man of Bernard Madoff's prominence (well known financial executive and former Chairman of the Nasdaq Stock Market) is a crook, investors naturally begin wondering if their own money manager is a crook. They'll make inquiries, and perhaps check with other sources. Many of them will submit withdrawal requests, preferring to live with the low returns that accompany federal deposit insurance than the possibility that they could lose everything. Those withdrawal requests will be like a hound flushing a rabbit, forcing whatever other frauds there might be out into the open when the fraudster can't honor the withdrawal requests.

Are there other Madoff-like scams? We don't know, but probably yes. Money managers, as Madoff purported to be, need to do better, somehow, than the market. There's no need to hire a money manager if all the performance you'll get is the market average. An inexpensive index fund is a much easier and more profitable way to go.

According to news reports, Bernie Madoff claimed to have an investment strategy that would produce unusually stable earnings. If you can take the volatility out of the stock market, but produce stock market-like 8% to 12% per year returns on average, your product will be an easy sell with the monied classes. Think back, say, to the stock market volatility of the last few months and you'll see the appeal of stable, stock market-like returns. Of course, as reported, Madoff didn't really have a magic investment formula that did away with volatility, and the recent volatility of the stock market did him in when he couldn't honor investor withdrawal requests.

Other money managers make their own claims as to how they'll improve on the market. But what if the law of averages catches up with them and they can't meet their claims? The honest ones will admit their failings and take their lumps. The sleazy ones will perpetrate a fraud.

Rising financial markets cover up a multitude of frauds. Good times draw investment dollars into the market and make investors inclined to believe that anything is possible. But the law of averages hasn't been repealed and markets also fall. Falling financial markets reveal frauds, when investors try to pull out and discover they can't get their money back. Unless you've been hanging with Rip van Winkle for the last year, you've probably noticed that our financial markets have been bungee jumping without a rope. As the financial tide ebbs low, all kinds of scum will be exposed.

Investor withdrawal requests were a major reason for the sharp drop in the stock market in September, October and November of this year. The market has, momentarily, appeared to level off. The Madoff case, and any others of its ilk that emerge, will probably trigger more investor withdrawal requests. If the money managers are legit, they'll have to sell securities in order to meet those requests. If the money managers are crooks, the ensuing scandal will further erode investor confidence. Either way, the existence of, or even potential for, more large Ponzi schemes a la Bernie Madoff will dampen already battered investor spirits and add to the sell pressure in the market.

Will the impact of the Madoff scandal and any others like it drive the stock market down? That's hard to say. The Federal Reserve has printed a trillion dollars plus in the last three months in order to prop up the financial system, and there's no limit on how much more it can print. It's also evident that the Fed and other federal authorities are intent on supporting stock market values, regardless of what they might have said to the contrary. But no amount of government bookkeeping--in actuality, the Fed creates money by making computer entries on its records of the accounts of member banks--can serve as a long term substitute for investor confidence. We now have a continuing mortgage crisis, a widening credit crunch, worldwide recession and a mega scam, and it's not at all clear that the federal cavalry riding over the crest of the hill can slay all these dragons.