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In 2008-2009 Bernie Madoff made headlines throughout the financial world when his wealth management business, Bernard L. Madoff, Investment Securities, LLC was discovered to have defrauded investors of billions and billions of dollars (estimates ranged from 18 billion to as high as 65 billion dollars, although $20 billion dollars stolen appears to be closer to the truth).

How did investors get duped by Madoff?

It was the lure of promised returns.

Madoff’s investment firm claimed an average annual return of 11% with very little volatility.

He was like the pied piper for investors and they blindly followed him.

 

 

Because of his long tenure in the finance industry (the technology his firm developed pioneered the formation of the NASDAQ), Bernie had wealthy investors ready to hand over large sums of money unquestioningly.

So elaborate was this scam that it is still uncertain when it actually began (in some interviews Madoff said he started in 1987, in others it was 1992).

And how did Bernie pull off a scam of this magnitude for so long?

Two words: Ponzi Scheme

A Little Background History:

Charles Ponzi was the mastermind behind an epic scam that bears his name (also referred to as a pyramid scheme).

 

 

Charles was born in Italy in 1882.

In 1903 he arrived in the United States with about $2.50 in his pocket (worth about $67.25 in 2018 dollars).

“I landed in this country with $2.50 in cash and $1 million in hopes and those hopes never left me”-Charles Ponzi

In 1919, Ponzi branched out with his own business and in the course of his dealings discovered a financial opportunity he could exploit, international reply coupons (IRC).

The intended purpose of these coupons was that someone could send correspondence internationally and the recipient could use this coupon to send a reply.

 

 

With great financial insight, Ponzi quickly realized that he could take advantage of a potential exchange rate (IRCs were priced at the cost of postage in the country of origin and could be exchanged for stamps to cover postage in the country redeemed).

If there was a difference in value in this exchange, a profit could be realized.

With inflation running rampant from World War I, IRCs purchased in Italy fulfilled the criteria needed to realize profits when exchanged for postage in the US.

Calculating expenses, Ponzi realized that the overall transaction netted a 400% profit, completely legal, using this currency arbitrage.

Needing capital to start this venture, Ponzi formed his own stock company, which was later named the Securities Exchange Company.

Investors were promised 50% return after 45 days and when he began to deliver on that promise word quickly spread.

Soon more and more investors were handing over their money to Ponzi who gladly accepted it.

The problem was the scalability of this venture.

The initial round of investing brought in about $1800.

This required approximately 53,000 IRC coupons to capture the IRC exchange profits necessary.

As more and more investors poured in (at the height of this scheme in July 1920 his company was bringing in $1 million/day) there were simply not enough IRCs that could be obtained and sold (it had gotten out of hand much earlier).

How Ponzi was able to manipulate these large transactions and still give investors promised returns was to build a pyramid scheme.

As more and more investors came in on later rounds, they built the base of the pyramid.

New money coming in was not buying IRCs at all, but simply turned around and returned to older investors as purported profit.

As long as the base was growing, the top of the pyramid could be held up.

This is where the financial venture turned from legal profits from arbitrage of currency to illegally stated profits and the Ponzi scheme was born.

Pyramid schemes by definition cannot be sustained for long periods of time.

Eventually there is not enough new investors/new money to sustain the promised returns to older investors.

When this happens and returns diminish or disappear, investors then start redeeming their original investments.

At a certain tipping point there will be a “run on the bank” and redemptions will exceed available cash and the whole house of cards falls down, which happened to Ponzi in August 1920.

When all was said and done, Ponzi’s investors lost around $20 million (approximately $261 million in 2018 dollars).

Ponzi was facing a lifetime in jail for 86 counts of mail fraud however he plea bargained and spent a total of 14 years in prison.

Bernie Madoff took the pyramid scheme to a much grander scale (53x magnitude to Ponzi) with his downfall initiated by the financial crisis when investors began redeeming money totaling $7 billion when there was only $200-300 million left.

On June 29, 2009 Madoff was sentenced to 150 years of federal prison at the age of 71.

“Okay Xrayvsn.  Thanks for the history lesson but what does that have to do with dear old Uncle Sam!?!?!?”

 

 

Can you think of any government policy/program that can be thought of as a pyramid scheme in the making, having incoming “investors” buy in to support older “investors?”

If the first thing that pops into your mind is Social Security then you’re a winner.

“As a result of changes to Social Security enacted in 1983, benefits are now expected to be payable in full on a timely basis until 2037, when the trust fund reserves are projected to become exhausted.  At the point where the reserves are used up, continuing taxes are expected to be enough to pay 76 percent of scheduled benefits.”- Social Security Office

As the population ages and more and more social security benefits begin getting claimed, there will be a tipping point where the base of the pyramid (younger taxed workforce) cannot sustain the top anymore.

Two things can happen.

The whole system falls down again like a house of cards or, more likely, there will be decrease in benefits/increase in age of retirement and/or higher taxes from the workforce.

Unlike the Ponzi/Madoff cases, these are mandatory “investments” in the form of required taxes.

So we all should look to (and thank) the younger generations ahead of us as they will be much needed to continue the ever-growing pyramid base.

 

Given the magnitude of money in play (around $2.6 trillion in the social security trust fund), this makes both Bernie and Charles look like amateurs.

Side note:

Remember that Social Security benefits are highly regressive (the % of benefits received compared to contribution amount has “inflection” or “bend” points with subsequent decreasing levels of benefit after each bend point).

Physician on Fire does a wonderful explanation of this phenomena.