Bernie Madoff: the confidence man

Published: Apr 2015
Cat casting shadow of lion

Now serving the sixth year of a 150 year prison sentence, Bernie Madoff was arrested at the height of the financial crisis, in 2008, after he admitted to running a $65 billion Ponzi scheme. The revelation sent shock waves across a society already reeling from the economic turmoil and put a face to what Americans saw as being wrong with the financial industry. Broader society was shocked, and his investors were traumatised and could not believe that a man they placed not only their money with, but also their confidence in, was a fraud.

Early life

Bernard Lawrence Madoff was born into a middle class Jewish family, in April 1938, to Ralph and Sylvia Madoff, the children of eastern European immigrants. The young Bernie Madoff was not outstanding academically but after leaving high school went on to study political science at the University of Alabama and then later Hofstra University in New York. Once he had graduated, Madoff split his time for a year between studying law at the Brooklyn Law School and running a small business selling and installing sprinkler systems. He also worked part-time as a lifeguard at weekends.

It was during this time that Madoff stepped into the world of finance and established Bernard L. Madoff Investment Securities. Some say that this is actually the moment his deception began as there is debate surrounding where Madoff obtained the money to start the firm. He claims that the company was set up with $5,000 he had saved, although others claim that the money actually came from the father of his childhood sweetheart, and wife, Ruth.

Either way, Madoff was an outsider on Wall Street, with no connections or pedigree, and according to his first US Securities and Exchange Commission (SEC) filing ‘cash on hand of $200.’

A legitimate businessman?

Madoff began his career in finance dealing in over-the-counter penny stocks acting as a market maker. In an interview with the NY Mag following his arrest, Madoff recalls his early days in finance as being frustrating and a world that he wasn’t truly part of. “It was always a business where you had to have an edge, and the little guy never got a break. The institutions controlled everything.” Madoff felt he was on the outside looking in; “I was upset with the whole idea of not being in the club. I was this little Jewish guy from Brooklyn.”

Operating on the fringes did have some advantages for Madoff, however. It was not institutionalised and there was no central exchange providing up-to-date prices on the stocks. Dealers in this market were able to issue quotes that, if completed correctly, could see them take a spread of up to a dollar a share, making a tidy profit. The practice was legal and by quickly learning how to play the game, Madoff started to become a successful businessman. According to SEC disclosures, by 1961 he had turned his initial investment into $16,140 and subsequently into $555,157 in 1969.

There was nothing particularly special about Madoff’s Ponzi – it worked as all classic schemes did, using money from new investors to pay old investors false returns. What was unique however, was its sheer size and longevity.

In the 1970s, new regulation began to allow firms such as Madoff’s to trade more prestigious blue-chip stocks and he began to gain market share in this area. As the decade progressed, Madoff developed a reputation for being a forward-thinker and his firm was one of the pioneers in electronic trading. In fact, Madoff claims that it was he and his brother who laid the foundations for the NASDAQ to be created in 1971 and that he had a defining role in shaping the new exchange. These claims have been countered by others involved in electronic trading at the time who say that Madoff was not involved in creating the NASDAQ at all and actually made his mark in electronic trading later.

Despite this, Bernard L. Madoff Investment Securities was certainly one of the first companies on Wall Street to truly harness technology. The firm specialised in trading over-the-counter with retail brokers, bypassing the exchange specialists using the new trading technology. Soon, Madoff was becoming a big player on Wall Street and began working with huge institutions such as Fidelity and Charles Schwab, and by 1990 executed around 9% of all trades on the NYSE.

Madoff’s stock had risen so high that in the same year he was appointed as Chairman of the NASDAQ and was regarded as the voice of authority on matters surrounding electronic trading, testifying in front of Congress and playing a key role in shaping regulation. Throughout the 1990s, his firm matched his success – growing in size and earning a considerable, honest profit.

The start of the Ponzi

On the 17th floor of 53rd at Third, the office block in New York, which housed Bernard L. Madoff Investment Securities, also resided his other business. Manned by no more than 24 employees, it was from here that Madoff would orchestrate the largest Ponzi scheme in history.

It remains unclear when Madoff began to manage money for clients, due to bad record keeping, yet many speculate that it began in the 1960s. Initially, the operation was small and his investor base largely came from his family and friends throughout the local Jewish community. As time progressed, Madoff’s client list expanded, assisted by his father-in-law, Saul Alpern who channelled him clients. Soon Madoff’s operation had four key clients: New York investors Jeffry Picower and Stanley Chais; Norman Levy, a real estate developer; and Boston clothing manufacturer Carl Shapiro, all of whom over the years would earn a lot of money through Madoff, even more so than Madoff himself.

Just as it remains unclear when Madoff began managing client money, it also remains unclear whether it was ever a legitimate operation. Unsurprisingly, Madoff claims that it was legitimate and that the Ponzi scheme didn’t begin until 1992. He also claimed that he lost a significant amount of money trading that year and rather than coming clean to his investors, he doctored the numbers, hoping that he would eventually recoup the losses.

In an interview with the Financial Times, Madoff highlighted that it was his ego that stopped him coming clean to his investors. “Put yourself in my place. Your whole career you are outside the ‘club’ but then suddenly you have all the big banks – Deutsche Bank, Credit Suisse – all their chairmen, knocking on your door.” Other notable experts on Madoff, including New York Times reporter Diana B. Henriques believe that this story is fabricated and Madoff’s Ponzi had in fact begun long before.

There was nothing particularly special about Madoff’s Ponzi – it worked as all classic schemes did, using money from new investors to pay old investors false returns. What was unique however, was its sheer size and longevity. Traditionally, Ponzi schemes quickly collapse under their own weight, yet Madoff was able to continuously attract new investment and come the end he was ‘managing’ more money than many of the largest institutions on Wall Street.

An exclusive club

So how did Madoff turn a small money management business into the world’s largest scam? The answer, as one might expect because of the size of the scheme, is complex. But the first and vital ingredient was having something to offer to the investor community, in Madoff’s case: steady returns. His investment fund offered returns of around 1% a month, good at the time but not fantastic. But what appealed was that the returns were consistent no matter how volatile the market was. To achieve this, Madoff claimed he was using an investment strategy called ‘split-strike conversion’, a method that saw him investing in a basket of S&P 100 stocks, using a mixture of ‘opportunistic timing’ and a variety of options in order to reduce volatility and in turn limit losses.

In reality, Madoff wasn’t doing anything with the money. He didn’t make any trades and the reports that he sent back to investors were fabricated. Any ‘returns’ were actually paid from new investor’s deposits – and there were plenty of these.

Initially, Madoff’s scheme was run by word of mouth – a friend would tell a friend about their investment and the steady returns, and they would want a slice of the action. But Madoff’s real masterstroke came from his rejections, of even high-wealth investors. In an interview with the New York Times, Jeffery Gural, Chairman of Newmark Knight Frank talked about how he was teased by friends after being turned away by Madoff. “They thought Bernie Madoff was a genius, and that anyone who didn’t give him their money was a fool,” he said. Of course, as Madoff’s scheme gained more notoriety, so did his clients, who invested in Madoff through feeder funds across the world.

The scheme’s appeal was only further reinforced when investors met Madoff in person. As Jerry Reisman, who socialised with Madoff, explained in an interview with the Daily Telegraph: “he moved in some of the best social circles in New York. He worked the best country clubs. He was utterly charming. He was a master at meeting people and creating this aura. People looked at him as a superhero.”

Madoff built up his image even further by working with charities, either as an advisor or by allowing them to invest with him. This not only boosted his legitimacy but by also accepting charities’ money, Madoff gained sticky deposits – which goes some way to explaining the longevity of Madoff’s scheme.

He moved in some of the best social circles in New York. He worked the best country clubs. He was utterly charming. He was a master at meeting people and creating this aura. People looked at him as a superhero.

Jerry Reisman

The final pillar supporting the ‘success’ of Madoff’s scheme was his close relationship with regulators, most notably the SEC. “Bernie had a good reputation at the SEC with a lot of highly placed people as an innovator, as somebody who speaks his mind and knows what’s going on in the industry. I think he was seen as a valuable resource to the commission in its deliberations on things like market data,” said Donald C. Langevoort, a Georgetown University law professor who served with Madoff on an SEC advisory committee, in an interview with the Washington Post.

As such, despite the spotlight being shone on his operations on a few occasions, Madoff was never formally investigated. This is also in spite of one man telling the SEC, for over half a decade, that Madoff was running a Ponzi.

Getting caught out

It all began to unravel for Madoff in 2008, as the global financial crisis began to take hold and markets came crashing down. His investors quickly began to request withdrawals from Madoff’s fund as their other investments disappeared. By December 2008, this figure had reached close to $7 billion. Madoff, with no means of obtaining this money, had run out of places to turn to and admitted his crimes to his two sons in their New York apartment. He was arrested the following day and so began the exposé of the biggest Ponzi scheme the world had ever seen.

Despite the spotlight being shone on his operations on a few occasions, Madoff was never formally investigated. This is also in spite of one man telling the SEC, for over half a decade, that Madoff was running a Ponzi.

For some astute observers, this came as no surprise. Madoff had actually been foiled eight years earlier by Harry Markopolos, a portfolio manager at Rampart Investment Management, an options trading company based in Boston. Markopolos was made aware of Madoff through an acquaintance, however, he had little detail about him so sent his colleague Frank Casey to investigate how this anonymous hedge fund manager was consistently obtaining 1% a month returns.

Casey went to meet Markopolos’s contact, Thierry de la Villehuchet, principle at Access International Advisors, a feeder fund to Madoff. Villehuchet explained how Madoff made his steady returns, regurgitating perfectly what Madoff had told him. Suspicious of how this strategy could work in a negative environment, Casey took the reports Villehuchet had provided back to Markopolos who instantly knew something was wrong. “It took me five minutes to know that it was a fraud,” he later said in an interview with CBS. “It took me another almost four hours of mathematical modelling to prove that it was a fraud.”

A fraud yes, but not necessarily a Ponzi – Markopolos initially believed that Madoff might be using insider information to make his profit – either way it was illegal. Markopolos took his case to the SEC, not once, not twice but three times over a five year period highlighting that what Madoff was doing was illegal and in the later instances a Ponzi scheme. “By 2005, I had 29 red flags that you just couldn’t miss on. By 2005, the degree of certainty was approaching 100%,” he told CBS. He explained that Madoff, to execute his strategy would have had to have bought more options than existed on the Chicago Board Options Exchange, yet Markopolos could not find one individual that had traded with Madoff.

Despite this, no formal investigation was ever launched by the SEC and Madoff continued his illicit activities until, like all Ponzi schemes, it collapsed under its own weight. On 12th March 2009, Bernie Madoff pleaded guilty to 11 federal crimes, claiming that it was he and only he who had defrauded his clients of $65 billion over 20 years. He was later sentenced to 150 years in prison.

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