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The tale of Bernard Madoff?s approximately $50 bn fraud is a fascinating one. In size, it is the largest investment fraud perpetrated by an individual, but besides that, it was a rather classic example of a Ponzi or pyramid scheme and an excellent investment lesson for all of us of some of the signs to avoid.

The tale of Bernard Madoff?s (pronounced, ironically, made off) approximately $50 bn fraud is a fascinating one. In size, it is the largest investment fraud perpetrated by an individual, but besides that, it was a rather classic example of a Ponzi or pyramid scheme and an excellent investment lesson for all of us of some of the signs to avoid.

It is particularly instructive that the fraud was perpetrated under the noses of the US SEC and despite the ?due diligence? of the European aristocracy of private banking. Many of the executives of institutions that reportedy lost, or lost on behalf of the clients, hundreds of millions of dollars, such as Union Bancaire Privee, BNP Paribas, BBVA and Man Group were probably the same executives who scoffed at stories of Ponzi schemes in the Philippines, Haiti and Jamaica as things that happened in other places where the rule of law, business moralty and public education were not as strong as they were used to. No country should consider itself immune from fraudulent investment schemes, though if anything, it appears that the United States is particularly vulnerable.

A Ponzi scheme pays out returns to investors out of the money paid in by subsequent investors, rather than from actual profit on their investments. Before progressing I should say inspiration for this article comes from conversations with Brian Wynter, who helped to establish and manage the Jamaican Financial Services Commission which became a world-class expert in Ponzi schemes. One of the misunderstood aspects of Ponzi schemes is that the biggest winner may not be the operator of the scheme, who is often the sole target of opprobrium when the scheme fails, but those early investors who got their money and more back at the direct expense of later investors. The oxygen of a Ponzi scheme is the flow of new investors to give old investors their returns. It is the old investors who are making out like bandits.

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Because they need an increasing flow of new investors, Ponzi schemes usually offer abnormally high short-term returns. One of the earliest such schemes was orchestrated in 1899 in Brooklyn, New York, by William ?520 Percent? Miller. He offered investors an interest of 10% per week and more if they reinvested their money. He defrauded investors out of $1 m. Charles Ponzi?s 1919-1920 scheme promised 50% interest on investments after 45 days or ?double your money? in 90 days. (Although Mr Ponzi did not invent the scheme, subsequent schemes were named after him because his was the largest up to that point with up to 40,000 investors losing as much as $15 m.)

High rates of return and an exponential increase in numbers of investors are tell-tale signs of a Ponzi scheme that were partially absent in Mr Madoff?s case. He still needed new investors, but his appeal to these investors was that he was offering good, but steady returns in an era of volatility, and, he was credible, having helped to establish, and having been a chairman of the Nasdaq as well as running one of the largest stock brokerages. In 2008 for instance, while stocks were down almost 50%, Madoff reported the unspectacular, but decidedly attractive positive returns of 5%. Because these returns were relatively modest and the allure of exclusivity he generated kept investors re-investing, the required rate of investor inflow was far lower than in other schemes. This allowed Mr Madoff?s operation to sit below the radar for a long time. Normally, Ponzi schemes burn themselves out in months, Mr Madoff?s appears to have lasted over 20 years.

One aspect of Ponzi schemes that Mr Madoff followed closely is the affinity group. This is a neglected aspect of these schemes and helps to explain their success and places them in an important social context. The operator of a Ponzi scheme is often part of a group who feel excluded from the cozy world of finance and are overly ready to believe that one of their kind, who shows a commitment to their community in other ways, has found a clever way to beat the ?waspish? financial community at its own game. Life changing rates of return are an attraction, but the community grounding fights off the naysayers. Mr Madoff exploited his Jewish connections, making many donations to Jewish charities, getting on to the boards of these charities, mixing with other wealthy people from the community and attracting their money into his fund. Likewise Charles Ponzi was hailed as a hero in the Italian immigrant community. In one of the pre-Ponzi, Ponzi schemes, Sarah Howe established the Ladies Deposit in 1880 in Boston for women only, offering 8% interest per month. The schemes which emerged in Haiti in the 1980s and Jamaica in the 1990s were based in poor communities that looked to the schemes to deliver salvation from poverty. Dream busters are not popular and the community aspect of these schemes makes it politically hard for regulators to intervene before schemes go bust even when they are suspicious.

Other aspects of Ponzi schemes that you should look for is the lack of independent governance with the schemes often run, owned and audited by family members or one person. And then of course there is the age old litmus test: can you understand how the returns were generated? This fail safe test is often passed over because people are too embarrassed to say that they do not understand something that others appear to understand. You don?t need persuading of that, do you? Consequently Ponzi schemes all tend to have an element of believability about them and an equal amount of complexity that intimidates the curious and pushes off the tough questioning. Mr Madoff claimed to buy stocks correlated with the Index and to raise the rate of return by selling out-of-the-money calls on the Index and to limit losses by buying puts on the Index. This strategy can provide a smoother return than just owning the stocks, but the net premiums on the options cannot generate a substantially higher rate of return than the market, or a consistently positive return when the market is collapsing. Like most frauds, Mr Madoff was found out, not by the curious, but by a collapsing market that forced investors to ask for their money back?not because they questioned that it was there?but just because they needed the cash.

The author is chairman of London-based Intelligence Capital, governor of the London School of Economics and emeritus professor of Gresham College in the UK

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First published on: 01-01-2009 at 00:59 IST