Taking Stock / Charles Ponzi Returns

Bull market? Madoff's fund made 10%. Bear market? 10%. Should everyone have known better? Yes

1Charles Ponzi: An Italian who emigrated to the United States in 1903. In less than 15 years he'd become a multimillionaire by dint of bilking thousands of credulous investors.

His system was simple. He took people's money and promised them returns of 50% in 45 days. Ponzi's investments naturally didn't make any such returns. He financed payment to his investors using money he took from new clients who came in because they'd heard of the genius achieving 50% yields in 45 days.

His success was phenomenal. He recruited dozens of agents who hawked his "investment fund." Not only did Ponzi become filthy rich, he became an icon of the business community.

What brought him down was a furniture dealer who sued Ponzi after being stiffed. When it turned out that Ponzi had liquidity problems, suspicions began to arise. He was tried, twice, and sent to prison, once for five years and once for nine. But he escaped and fled to Florida, where he tried to con investors in much the same way, this time focusing on the real estate market. Again he was caught, did his time, was released and finally died in Brazil without a penny to his name.

Since then, fraud perpetrated by paying off veteran investors using money from new suckers has been called a "Ponzi scheme."

Ponzi schemes come in variations, such as pyramid schemes, where each investor who comes in markets the fraud himself to the next investor. That ends when there are no more people to be had. In Ponzi schemes, there's only one winner: the con man at the top who milks all the chumps.

Madoff ran one of the most successful hedge funds in the world. His clientele included some of the smartest and most successful people in the world.

Now we know that Madoff was just a latter-day Ponzi. In the spirit of the times, he went for it big. In the last 10 years he raised NIS 17 billion for his fund, which returned 10% a year, with tiny fluctuations, more than double the returns that risk-free investments are supposed to achieve.

The SEC ignored his letter, but he persisted. For the last nine years he's been writing to authorities in New York and Boston, sending more and more documents and data based on which he argued that Madoff was just another Ponzi. A week and a half ago, the SEC started investigating Madoff after one of his sons turned him into the police.

The SEC had plenty of grounds to suspect that Bernie Madoff's returns were fictitious. His clever investors should have smelled a rat, too. Red flags were waving wildly all over his operation. There were no independent auditors. There was no independent trustee looking after the clients' money. There was no independent broker handling the money, as is the norm in hedge funds.

But the most obvious warning sign was the steadiness of Madoff's returns - 10% a year. The stock market boomed? 10%. It crashed? 10%. The dot-com bubble exploded? 10%. Russia collapsed? 10%. Year in and year out, 10%.

This year the fund did especially well. By the end of November, it was reporting positive returns of 5.6%, while the S&P-500 index in which it was supposed to be investing lost 37%. In "black October," when that benchmark index lost 17%, Madoff's fund gained a little over 1%.

Shouldn't that have alerted investors that something was fishy? It should have. Did it? Apparently not. Why? Because when people are making money, they want to believe they can continue to make money.

How did Madoff achieve returns of 10% a year? Simple. Each month he presented earnings of 1% to 2%. Did the market fall? He didn't. Was the market volatile? Not Madoff. The yield curve of his hedge fund doesn't look like any other yield curve of any other fund or security - it's a straight line at an angle of 10% a year.

Despite that screaming warning siren, the savants of Wall Street hared for his fund. Why? Again - because they wanted to make money.

Didn't any of them suspect something? Sure, some probably did figure it was some kind of fraud, but they didn't care as long as it played in their favor.

Investing in his fund became a status symbol. If you were with him, apparently you were rich and smart, too. Last week a few dozen billionaires, hundreds of millionaires and several dozen public bodies that had deposited money with Madoff learned that they are a lot less wealthy than they thought, and not so smart, either.

Lewis documented a number of characters who became legends on Wall Street. One was John Meriwether, who was the manager of Long-Term Capital Management, the giant hedge fund whose collapse in 1998 triggered a global financial crisis, though the markets rebounded from it pretty fast.

Lewis left his job at Salomon at age 29, he wrote, with a queasy feeling that something on Wall Street was rotten. He felt it unsound that mountains of money were being earned by kids who didn't have a clue what they were doing. He felt that something had to happen, it had to come crashing down.

Last month Lewis published a long article in the U.S. press, writing that it did come crashing down. The Wall Street era was over.

When did Lewis write "Liar's Poker," predicting an end to the fest? A year ago? Two? No, he wrote it in 1989. Even then he felt that something was wrong on Wall Street.

Think again. You are surrounded by people, companies and whole economies touched by the drama on Wall Street.

This isn't a crisis of tycoons. It involves us all.

When the dot-com bubble burst seven years ago, many high-tech companies gloated that they had no connection with dot-coms, so they'd be fine. In a quarter or two they realized that their customers were involved in dot-com businesses, directly or indirectly, and their sales evaporated.

It was purely symbolic that the Madoff bubble burst this week. The timing was not a coincidence. Madoff could juggle billions of balls as long as money was cheap and the markets were booming. When the market collapsed, even the double and triple accounts he was running couldn't keep his balls in the air. He was forced to surrender to the police.