Wall Street investor Bernard Madoff is not the first person to be charged with carrying out a massive Ponzi scheme. Sometimes people call it "robbing Peter to pay Paul," or a shell game. Pyramid schemes are close relatives. By any name, the Ponzi scheme has a long and colorful history.
RENEE MONTAGNE, host:
And, Steve, that massive Ponzi scheme that you and Jim were just talking about, sometimes people call this robbing Peter to pay Paul, or a shell game, pyramid schemes, or close relatives. And as NPR's Yuki Noguchi reports, this particular crime goes way back.
YUKI NOGUCHI: Charles Ponzi, for whom this crime is named, wasn't even the first to perpetrate it.
Professor MITCHELL ZUCKOFF (Journalism, Boston University): A guy who preceded him, who was pretty well known in his day, was a guy named Franklin Miller, who was known as 520 percent Miller.
NOGUCHI: Mitchell Zuckoff is a professor at Boston University and wrote a book about the history of Ponzi schemes. A century ago, Miller promised 10 percent returns on stocks a week - so 520 percent a year. Audacious, but it's Ponzi we remember, not Miller.
Professor ZUCKOFF: It doesn't sort of trip off the tongue quite as nicely, a Miller scheme, as a Ponzi scheme. There's something, I don't know, something sonorous about the name.
NOGUCHI: And so Ponzi it was. Ponzi purported to buy and sell international postage in different currencies at a profit, and that drew huge numbers of investors.
Professor ZUCKOFF: He walked down the street, and it was like a parade started behind him.
NOGUCHI: So many, in fact, the amount of money invested exceeded the value of the stamps in circulation. Instead of paying investors with real profits, he redistributed cash, which is the essence of how these plans work. Let's say I start a Ponzi scheme. I've got this foolproof investment strategy that involves puts and calls and swaps - and anyway it's totally foolproof, OK? OK. And it makes 20 percent returns even in this economy.
I take the money and maybe invest some of it in stocks or Treasuries and, naturally, buy myself some nice cars, boats, and luxury homes. The point is I'm never specific about where the remaining money goes or how it's invested. As long as I keep attracting new investors, it all seems good, even if a few people want to withdraw. But if a lot of people want out, there's trouble. Chris Geczy is an adjunct professor of finance at Wharton.
Dr. CHRIS GECZY (Adjunct Professor of Finance, The Wharton School): Because either I have to raise an inordinate amount of capital in order to pay out, or I have to delay or prevent people from taking their money out, which of course induces examination.
NOGUCHI: Ponzi's famous scheme ran its disastrous course within a year. By August of 1920 his jig was up. By comparison, Madoff's might have spanned two decades. Again, here's Professor Geczy at Wharton.
Dr. GECZY: And that's a long time to perpetrate anything. That might be longer than most people perpetrate their marriages.
NOGUCHI: And, of course, the sheer scale of Madoff's enterprise made it dwarf all others before it. Geczy says it's likely Madoff actually did make money in the market for a long time. Funds like his escaped relatively unscathed during the bust of early 2000.
Dr. GECZY: That almost surely gave rise to the ability to raise more money because investors went through that experience and were looking for hedges.
NOGUCHI: Then his investors rode the credit-fueled boom. And only this month, when investors asked to withdraw $7 billion, did the music stop. Boston University's Mitchell Zuckoff says no one knows when he went from being a legitimate money manager to a guy running an alleged Ponzi scheme. But what often happens to money managers who hit a rough patch is that they don't want to admit they lost their touch.
Professor ZUCKOFF: The world passed him by, and he couldn't accept that he was no longer the man.
NOGUCHI: That was something his predecessor, Charles Ponzi, also struggled to accept.
Professor ZUCKOFF: At the end of his trial, he scribbled a note on a legal pad, and he passed it to the reporters in the front row of his trial. And it said in Latin, "Sic transit gloria mundi," which of course means, "Thus passes worldly glory."
NOGUCHI: Bernard Madoff is scheduled to make another court appearance today. Yuki Noguchi, NPR News.
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The FBI says it has set up a hotline for investors who believe they were cheated by money manager Bernie Madoff. Officials are hoping to collect any documents or other evidence that might shed light on how the scandal unfolded.
The arrest of Madoff, a revered figure on Wall Street, has sent shock waves throughout the financial industry. But there were also those who tried to warn regulators about Madoff, and they say authorities failed to act against him until it was much too late.
Bernie Madoff's reputation as a money manager was so great that investors literally pleaded with him to take their money. He consistently made returns of 10 or 12 percent even in bad times. And hedge funds, charities and rich people were all dazzled by his track record.
But not everybody.
A few years ago, Millicent Holmes was working for a fund of funds — a sort of giant hedge fund that invests in lots of smaller funds — and she was looking for places to invest her clients' money.
"[I] contacted the firm, spoke with Madoff, who described the strategy in a very matter-of-fact way. When I called the firm back to discuss getting complete transparency on [the] trades, the information given at that point was very concerning," says Holmes.
Madoff told her he engaged in what's known in the investment world as a split-strike conversion strategy. That's when an investor tries to balance different kinds of options trades to provide predictable returns. But Holmes says Madoff's numbers didn't add up. She says trades as large as Madoff was claiming didn't seem to show up in the options markets. So she steered clear of him. And so did a lot of others.
"There were many, many people in the hedge fund industry that shared these reservations," she says.
Today Holmes works for Crowe Wealth Management, and she is surprised by how long it took regulators to go after Madoff. In 2001, Barron's ran an article questioning his returns.
"And many people in the hedge fund industry thought after that article the authorities would take a very close look at Madoff," she says. "Sadly, I don't think that happened."
Operating With Little Oversight
Why that didn't happen is a question a lot of people are asking right now. Madoff was able to operate for years with little apparent oversight from the Securities and Exchange Commission, and it's not clear regulators would have caught on to his crimes had his sons not turned him in.
Part of the problem was the dual nature of his operation. Arthur Levitt says back when he was chairman of the SEC in the 1990s, Madoff was mostly known for the trading firm that bore his name.
"He was a broker-dealer. That's all I knew about him," Levitt says. "He wasn't managing anybody's money as far as I knew, so nobody spoke about Madoff making money for them. He was making money for himself by trading."
But at some point Madoff also began attracting money and lots of it — some $17 billion for an array of distinguished clients. The SEC is supposed to inspect registered investment advisers on a regular basis. And they have the authority to look at their books anytime. But Joseph Grundfest, a professor of law and business at Stanford University, says the commission doesn't pursue such firms very aggressively.
"There are thousands of these firms out there and the SEC's inspection schedule doesn't allow it to get to them on a frequent basis," says Grundfest. Why is that? Grundfest says it is a question of resources and money.
But critics note that the SEC had received at least one complaint about Madoff's investment practices as far back as 1999. A securities industry executive warned that Madoff's returns were too good to be true and urged it to investigate him. Yet Madoff was able to keep operating and even register as an investment adviser in 2006.
SEC officials say they can't discuss what they knew or didn't know about Madoff because the case against him is still open.
What is clear is that U.S. officials appear to have done little to stop Madoff, even though a lot of other people in the financial markets were raising questions about him.