Understanding the Ponzi scheme

Before the financial crash, whenever Bernie Madoff visited the Palm Beach Country Club its members would beg him to let them join his investment scheme.

As the US economy showed signs of weakness, Madoff ’s fund was the only one that seemed to be doing well; some of the richest people in the US were moving all of their assets into his fund – some even refinancing their homes – because the returns looked so good.

To his investors, Madoff was a kindly, gentle man who really wanted to do right by them. He was known in financial circles as ‘Uncle Bernie’, a respected elder statesman of finance, a genius who knew how to make his clients rich. So, when it was unveiled that Madoff was running the biggest Ponzi scheme in history, it hit America’s rich hard.

Huge swathes of wealth were obliterated overnight. At the time of Madoff ’s arrest in 2008, the size of his fraud was estimated at $64.8bn (£48.4bn), with the number of individual investors (including those attached to ‘feeder funds’, which invested money in Madoff ’s scheme without their knowledge) totalling around 13,500, according to Vanity Fair journalist Mark Seal. Some of these were charitable foundations, with the fraud wiping out safety nets and community programmes for countless other people. Madoff ’s methods for attracting investors were simple.

Firstly, he let other people make recommendations for him. Among his key allies was well-respected businessman and philanthropist Carl Shapiro, who considered Madoff the son he never had and put his trust entirely in Madoff to manage his money. That trust reportedly cost him $550m (£411m).

Secondly, he reported modest but steady returns, making his fund seem like a safe bet for usually responsible investors.

Thirdly, the number of charities invested in the scheme allowed Madoff to easily predict what he would have to pay out each year. “For every $1bn [£747m] in foundation investment, Madoff was effectively on the hook for about $50m [£37m] in withdrawals a year,” wrote Mitchell Zuckoff , professor of journalism at Boston University and author of Ponzi’s Scheme: The True Story of a Financial Legend. “By targeting charities, Madoff could avoid the threat of sudden or unexpected withdrawals.”

While Madoff still seemed like a safe bet at the dawn of the financial crisis in 2008, within months his scheme came crashing down. Panicked investors tried to withdraw $7bn (£5bn) out of the fund, but that money wasn’t really there. His firm had less than $200m (£149m) in assets, and Madoff knew the game was up. He eventually confessed when confronted by federal agents in December 2008, having spent the days before writing out $173m (£129m) in ‘bonuses’ for family members who were employees at the firm.

In 2009, Madoff received a prison sentence of 150 years for one of the biggest frauds in history. Many investors, including celebrities such as Kevin Bacon, Zsa Zsa Gabor and Steven Spielberg, will never recover the money they lost. And, for many, especially close friends such as Shapiro, the betrayal was more painful than the financial loss. “It was like a knife to the heart,” Shapiro said later.

Mark Rowland is a journalist and former editor of Accounting Technician and 20 magazine.