The $50BN fraud

This is the latest scandal to hit Wall Street. The facts are simple. Bernard Madoff, a hedge fund manager, has for years apparently run one of the biggest scams on wall street. He essentially took money from new investors and paid off older investors with it. The entire house of cards has collapsed with the fall in the world markets. The aggregate losses to investors, which includes some big names across the world, is estimated to be $50BN. He has been arrested, and is out on bail.

The puzzling part is that for years, investors, bankers, lawyers, IRS agents and auditors all scrutinized his books and concluded he was completely above board. The fact that this could continue for years (some estimate 10+ years) without alerting any regulators has investors shaken. The BBC is reporting that this has shaken foreign investors' confidence in the US regulatory system to an extent that could potentially have serious consequences for the US.

By the way, this is a classic Ponzi scheme. A Ponzi scheme is one where you delude people into thinking you are making them money by paying them off with money from incoming investors. You can keep this going so long as everyone trusts you.

The term "Ponzi scheme" refers to Charles Ponzi. Charles Ponzi was by no means the first to conceive of this. However, he did do it more extravagantly than most. In 1920, he was involved in a scheme to make money off arbitrage on postage stamps that promised to "double your money in 90 days". He realized soon enough though that he didn't actually need to buy the postage stamps and exchange them as he promised. He could do it on his books and everyone would go along with him. So, he kept paying off people with the money he collected from incoming investors. Ultimately, his scheme collapsed leading to his ruin, arrest and jail. He died in poverty in Brazil. Before he died, he is reputed to have told a reporter, "Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over."