Academic

In finishing a short article about Bernard Madoff, I recently read Ponzi's Scheme:  The True Story of a Financial Legend by Mitchell Zuckoff.  What was very interesting about this day-by-day account of the summer of 1920 was the fact that Carlo/Charles Ponzi seemed to really think that he could figure a way out of the scheme.  In hindsight, this seems like a very optimistic, if not ignorant, hope.  Ponzi's scheme was to promise investors a 50% return in ninety days, which at the outset he thought he would fund by arbitraging the difference between the price of International Reply Coupons in the U.S. and in Italy.  Of course, he never actually got around to figuring out the logistics of doing this on a scale of more than a dollar's worth, so he simply paid off early investors with later investors. 

But he kept thinking he would stumble upon a scheme to pay off all investors at once and end with a clean slate, even at the end with state, federal and banking officials investigating him.  At the time that his investment scheme ended, he had contingent liabilities of at least $7 million, with assets of no more than $4 million, yet he thought new scheme would present itself.  He toyed with simply theft -- borrowing a few million from the bank that he controlled, Hanover Trust.  This worst-case scenario was taken off the table, however, when bank examiners ordered his bank drafts not to be accepted and the bank's accounts frozen.  Ponzi also thought he could sell to New York interests for $10 million, although his potential buyers wanted to know the secret to his investment success of 50% returns in 90 days.  Even after he was released from prison after four years, while appealling a Massachusetts state law conviction, he thought he could clear his name by paying off all his investors by starting a new land scheme in Florida.  Yes, literally swamp land.  This landed him only another criminal conviction to his name.  As a reader, I want a time machine to go back and tell him that there is no good exit strategy to a Ponzi scheme!

So what about Bernard Madoff?  He's a smart guy, surely smarter than Carlo Ponzi, who dropped out of the University of Rome and was in and out of prisons most of his early adulthood.  Surely he understand the math of the Ponzi scheme -- that at some point there aren't enough people on the earth to keep the finances of the Ponzi scheme going.  But Madoff's fraud was different in some ways that might have bought him more time, allowing his fraud to go on for 15-25 years.  First, he accepted investments mostly from those who would not ask for their principal back, if at all, for many years.  Widowers, retirees, those saving for retirement and college expenses, young people with inheritances, foundations, and those with vast amounts of wealth would be happy to see their money fictitiously go and live on the ten percent return, if they didn't reinvest that.  Madoff knew that a lot of inherited wealth passed from generation to generation with the principal intact; Madoff knew that a lot of people overinvest for their retirements and other expenses.  For those few redemptions, or relatively small redemptions (a college education there, a house here), new investments would take care of the call for redemptions.

But surely Madoff knew that eventually redemptions would exceed new investors, particularly if there was an economic downturn.  And surely Madoff knew, unlike Ponzi, that there wouldn't be some new scam available to pay off the liabilities of a mature scheme decades in the making.  So, what was exit strategy?  I have two theories.  The only exit strategy theory that I can come up with is that Madoff was betting that he would die before the scam was discovered.  This might not have been an implausible outcome.  Madoff was 71 when the scam was discovered.  I know nothing about his health or the longevity of his relatives, but it's possible that without an economic downturn, his scheme could have continued for the 10-15 years his attorneys argued were left in his natural life.  This strategy, of course, would necessarily mean that Madoff had no regard at all for his family.  Perhaps he thought the scam would outlive both he and his wife, Ruth, but it could never outlive his sons or his grandchildren.  If Madoff's wish was to have the scam be discovered only upon his death, then that is truly a Faustian bargain.

The second theory is that Madoff is not that smart.  Perhaps Madoff took solace in knowing that Carlo Ponzi's scheme actually didn't end because he couldn't meet current obligations.  Ponzi met his end because federal regulators began investigating him.  Though the Massachusetts attorney general and various other state and federal officials couldn't quite figure out what the crime was, bank regulators struck him where it hurt by freezing his assets so that he couldn't physically repay current obligations.  In the meantime, the Boston Post discovered he had been in prison in Canada, further getting him in trouble with bank regulators.  Then, and only then, Ponzi surrendered; however, he had never failed to repay an investor at that point.  Perhaps Madoff surmised that the take-away lesson from Ponzi was to stay one step ahead of regulators.  And we all know that he was able to do just that.  However, his scam outlived curious regulators, but it did not outlive the 2008 financial crisis.  In December 2008, Madoff faced redemption requests of $7 billion dollars, an even more astronomical figure to cover quickly than Ponzi's $7 million in future liabilities in 2008 dollars (about $75 million).  The last week of the scheme, he was trying to drum up interest in a hedge fund that would have a minimum investment of $100 million, but finding 70 investors with that liquidity in December 2008 seems almost as foolish as Ponzi's Florida swamp land scheme.

For any would-be Ponzian -- these things do not end well!