It looks like Bernie Madoff was $45 billion short of funds in his “investment strategy.” How was he ever going to get out of this?
The original Ponzi schemer, Charles Ponzi, seems to think he could get out of his situation, at least according to Mitchell Zukoff, author of Ponzi’s Scheme: The True Story of a Financial Legend.
It sounds like Madoff and Ponzi fell into the same trap. At some point early on they did not realize their promised investment goals. Instead of being honest with their investors, they posted a fake return. The hope was that they could make up for the miss later on.
The central characteristic of a Ponzi scheme is that current returns to investors are paid from new investments instead of a return on the invested capital.
The duration of a Ponzi scheme is dependent on a few factors.
The first factor is the promised return rate. The higher the promised return the shorter the duration. One of the reasons Madoff continued for so long is that his promised return was typically low. He was generally in the 15% range. Since Ponzi was promising returns of 50% in three months, he had a short fuse on the length of his scheme.
The second factor is the redemption rate. The promised return is only meaningful when you have to pay out cash. The better the schemer is at getting investors to keep rolling over returns, the longer the duration. Madoff was undone by the 2008 financial crisis, crushed by a wave of redemptions as people were desperate for cash.
The third factor is the investment rate. The better Ponzi schemers can keep the cash flowing in. As long as the investment rate of cash flowing is in excess of the redemption rate, the scheme will not collapse unless discovered. Once the redemption rate exceeds the investment rate, the schemer will not have the cash to make payouts and the scheme will likely be discovered.
The fourth factor is discovery. This is a wild card. Once an accusation of fraud is made, there will likely be an sharp increase in the redemption rate and a reduction in the investment rate. Ponzi has high profile and attracted attention. Madoff was very secretive. If you can’t stand up to scrutiny, the less scrutiny the better.
The fifth factor is actual returns. I would theorize that many Ponzi schemes start as a legitimate investment proposals. So there may be some actual investment returns that could offset the need for a higher investment rate. Ponzi never made a legitimate investment so this factor was zero for his scheme. Madoff was apparently investing legitimately at some point, but ended up at zero for many years leading up to the collapse. Stanford was generating returns in his banking empire. Just not enough.
The obvious exit is to increase the actual returns to meet the promised return rate before the redemption rate exceeds the investment rate. You can look at Sam Israel who seemed to think he was always just a few trades way from making back all of the promised money.
Sources:
- Is There an Exit Plan for a Ponzi Scheme? (Did Madoff Have an Exit Plan?) by Christine Hurt in The Conglomerate
- Hey Ponzi: What’s Your Exit Strategy, Exactly? by Catherine Rampell in The Economix in the New York Times.
- Ponzi’s Scheme: The True Story of a Financial Legend
- The Fall of Sam Israel
