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A couple of years ago India as a country, was facing a huge divide. The government of India had passed a new legislation which would allow foreign direct investment into the retail sector. This meant that global economic giants like Wal-Mart, Tesco and Sears were on their way to open up stores in India. Needless […]
Security Analysis and Portfolio Management
What is a Security ? Assets with some financial value are called securities. Characteristics of Securities Securities are tradable and represent a financial value. Securities are fungible. Classification of Securities Debt Securities: Tradable assets which have clearly defined terms and conditions are called debt securities. Financial instruments sold and purchased between parties with clearly mentioned […]
What is Convertible Debt?
The fixed-income security market is mostly composed of financial instruments which offer a fixed stream of income to investors. In other words, this means that the possible downside that investors may face is protected while at the same time investors can have only a limited upside. This is exactly opposed to stocks wherein the possible […]
Valuation of Sports Franchises: Discount Rate Calculation
In the previous article, we have already seen how the valuation of a sporting franchise can be found using the income approach. This approach relies extensively on finding out the cash flow that is likely to accrue to the sporting franchise and then discounting it at a predetermined discount rate in order to find out […]
The Phenomenon of House Poverty
Homeownership has been at the center of every American dream for the past few decades. The conventional belief is that buying a home always turns out to be a good investment in the long run. This is the reason why owning a home is considered to be one of the biggest and the most important […]
The Bernie Madoff scandal was a story of a $50 billion embezzlement and Ponzi scheme run by Madoff Securities LLC. The scandal broke out in 2008 and sent shockwaves in the United States as well as across the world.
The world had seen many Ponzi schemes. However, this one was unique given the fact that it had been running for over two decades in one of the most regulated markets in the world. The existence of the Madoff scam made people question the existence and competence of regulatory bodies like Securities Exchange Commission (SEC).
The SEC was not able to detect this scam till the very end. It is only when Madoff’s two sons got wind of their father s illegal operations that they reported the issue to the authorities and Madoff was arrested. Madoff was later charged with financial fraud and embezzlement to which he pled guilty without trial and is today serving his 150 year sentence in prison.
Bernie Madoff had started as a small time penny stock broker in the 1960’s. His claim to fame was software that was developed by his brother that could supposedly pick profitable trades within a few seconds. A lot of people invested with Madoff and made good money giving his company a good reputation. Soon Madoff LLC grew into a financial powerhouse and was the sixth largest market maker on Wall Street. Madoff became a very well respected figure on Wall Street and served on the boards of various stock exchanges as well.
Madoff had three lines of business. Apart from brokerage, he also conducted proprietary trading. However, it was the hedge fund that was the crown jewel of his empire. This was personally managed by Bernie Madoff and was the epicenter of the gigantic $50 billion embezzlement, probably the largest in world history.
Bernie Madoff’s hedge fund was a class apart. While other hedge funds were looked upon as speculators, Madoff was looked upon as an expert money manager. Other funds had erratic returns. Sometimes they would make a lot of money and at other times they would lose a lot. This is a fundamental characteristic of hedge funds and the basic reason why only accredited investors with more than a $200000 net worth can invest in them. The average investor is kept away from hedge funds by the government because of the massive risks involved.
Bernie’s fund had been giving a consistent return of close to 12% for decades. The fund had seemingly survived many recessions and crashes. However, the record was impeccable and 12% return worked like clockwork.
People would queue up to give Bernie their money and Bernie was very selective about who he did business with. Getting Bernie Madoff to manage their money became a status symbol amongst the wealthy as Bernie’s selectiveness gave him an aura of exclusivity and created a high end brand.
Needless to say, the reality of the funds managed by Madoff’s hedge funds was very different than what the illusion was. Madoff had no magical way of navigating the ups and downs of the market and always creating a 12% return at the end of it. In reality, Madoff was paying off the old investors by receiving money from the new ones. This is the very definition of a Ponzi scheme i.e. financial fraud!
Madoff was very selective about his investors because he mostly managed money for large charities and non profits. These institutions were regulated by the law and had predictable withdrawal patterns. Hence, Madoff maintained a percentage between the money managed for non profits and the money managed for private individuals. This would enable him to make payments if demanded by the investors and thereby prevent a run on the fund!
Bernie Madoff’s trusted aides had set up an entire secret operation wherein they would always pay a 12% return on withdrawal or even in the annual statements. His accomplices would simply reverse engineer the trades and claim to have purchased and sold certain securities which in retrospect would make achieving this return appear very probable. An entire software unit was set up on the mysterious 17th floor of the office wherein these fabricated statements were created. Investors did not have online access to their accounts and as such could not check their statements real time.
Madoff was reported on several times before the 2008 fallout. In fact, one investor had given a 21 page letter to the Boston SEC enumerating reasons as to why Madoff Investments could not be a legitimate business operation. However, surprisingly a blind eye was turned towards such complaints which were regarded as vicious attempts by jilted competitors to malign Madoff’s name.
In retrospect, Madoff’s significant influence in Washington could have played a major part in getting him off the hook multiple times. Also, Madoff’s niece was married to a senior SEC official making SEC part of the family too! However, no charges of corruption have been proven and from the public version of the tale, it seems like Madoff was simply smart enough to fend off the regulators several times and continue the Ponzi empire till it became fundamentally unsustainable in 2008.
Madoff is said to have confessed the situation to his two sons who reported it immediately to the regulators since they did not want to be part of the scandal.
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