The Madoff mess: How could it happen?

It's a question anyone who has spent time trying to understand the Madoff mess has to wonder: How could this happen? How could so many intelligent people be duped, look the other way, ignore or otherwise facilitate such a massive fraud? Part of it is that many benefited. Part is that many simply couldn't believe that a patina of respectability masked a massive fraud. And some suspected, but simply didn't know what was going on. Many people wondered what was happening with Madoff, but it's far from clear why people didn't point to a Ponzi scheme. It seems that even those who questioned Madoff's method were slow to suspect what, in retrospect, seems to be, if not inevitable, at least one sensible explanation. Barron's ran an article that, many say, was a first step in ripping off Madoff's mask. It actually, however, focused on concerns that Madoff was front running, using market information to make decisions. Many suspected that Madoff was trading on insider information or otherwise benefiting, placing orders based in data from his operation which handled transactions for firms such as Charles Schwab. David Kugel, a trader at Madoff's legitimate brokerage house later sentenced to 10 months home arrest, said he didn't think it was a Ponzi scheme, named for swindler Charles Ponzi. "He said it on the stand, so it's public information," said Greg Hagarty, a CPA and former FBI agent who worked the Madoff case and now runs Alpha Group Investigations in Farmingdale. "He said they never thought it was a Ponzi scheme. They always knew the trading downstairs was fraudulent. They knew it. They never thought it was a Ponzi scheme." Hagarty said Kugel told authorities he and another head trader would sit down and say, " Who's Bernie's Bernie?" "Bernie was paying people 14, 15 and 18 and 22 percent," Hagarty said. "People were very silo-ed. People in on the fraud side were screamed at if they talked to the people on the trading floor." Bernard L. Madoff Investment Securities Trustee Irving Picard believes Madoff started small and may have been happy that way, without creating a castle of cards that had to fall. "Like many frauds, based on our investigation, this started out very modestly," Picard said. "Small investors came to Madoff through various accounting firms." The SEC in 1992 cracked down on accounting firms that weren't registered as investment advisors, including those doing business with Madoff. That crackdown, ironically, fueled Madoff's fire. "Most of these firms were getting 18 percent returns from Bernie," Picard said of the fraud. "And they were paying the investors 12 percent." When a receiver was appointed for one of the major accounting firms that invested with Madoff, Picard said Madoff had to come up with about $440 million to repay investors. "He did that," Picard said. "At the same time as the investors were being paid, they got a telephone call that effectively said, 'Why don't you give the money back to me and I'll give you the same deal you had before?' Most of the people did that." Ironically, not only did most of that money flow back to Madoff, but many millions more also flowed in. Instead of dozens of accounts, Madoff took in more and more money to pay earlier account holders. He soon had several thousand accounts. Enforcement actually ended up leading to more investment in the fraud. "That's how the number of accounts exploded," Picard said. "Keeping this alive for the long term meant having to get a lot more money. That's where Bernie, being a good salesman, was able to start getting some of the larger feeder funds to start giving them money." The former chairman of NASDAQ, Madoff was responsible for significant volume of off market trading. In some ways, Madoff was the equivalent of a financial home-run hitter, shooting up on steroids. Feeder funds began to make money flow even faster to a man perceived, if not as the wizard of Wall Street, as one of its wise men. "You would assume this guy had gravitas, whether you were a sophisticated or unsophisticated investor," Picard said. When the economy began to collapse, Madoff moved money around more frantically. Even the "real" side of the business, the financial fig leaf over the fraud, began to take hits. "What may have looked like on the books as trading profits started turning to trading losses," Picard said. "We believe by that time the Ponzi scheme was well under way. Madoff sometimes covered his losses indirectly from funds in the investment advisory business, i.e. other people's money." Madoff sometimes transferred funds to a European related entity and then brought it back laundered through what Picard called "round-tripping." "His reputation and apparent success coupled with a low-key approach to selling drew unsophisticated investors to him," Picard said. Would-be investors have told Picard how they tried to invest with Madoff only to be turned down. "That was the way people started to believe this was a club," Picard said. "If you had somebody who could introduce you, you could get in." The feeder funds became the most important source of cash, bringing in a steady stream of new money, because Madoff needed what Picard called an "ever increasing amounts of money to feed his scam." When it was time to redeem funds, Madoff was able to convince people to let the money ride. Banks even created financial products around Madoff "to sell to their favorite customers." "Derivatives. We've heard about those," Picard said. "It gave some customers an opportunity to 'take advantage' of the famous Madoff returns." Madoff's investment advisory business grew to 8,000 customer accounts at its peak and 4,500 at the end of 2008 when it closed. The last time Madoff sent out information to clients, he sent out 4,900 statements Those final statements totaled $65 billion, but most of it was made up. The losses, based on money invested, were closer to $20 billion with about $17.5 billion in claims, Picard said. About $2.5 billion in accounts did not file claims, including some from foreign countries involving money likely being hidden in the United States. Published: Thu, Sep 24, 2015