Bernie Madoff was a scammer, a con artist, someone who ripped off his friends and led his son to commit suicide, an operator of the biggest ponzi scheme in history, taking in hundreds of millions of dollars and, instead of investing it, spending it on yachts, houses, and donations to fancy charities who feted him for his brilliance and generosity, someone who avoided taxes and ripped off rich and poor with equal enthusiasm, and he kept all this up for thirty years before the financial crisis of 2007 revealed that his business was a house of cards. All of which is to say that he was a regular Wall Streeter who just happened to get caught, right!?!? Well, actually, mostly not, and that’s an important point that is elided in Madoff – Monster on Wal Street - the Netflix series that animates this column.
Bernie Madoff grew up only ten miles from lower Manhattan, but as a Jew without an elite academic pedigree, he was about as far from Wall Street as anyone could be. Madoff started out as a market-maker for the stock of small companies, the kind that was ignored by the waspy, establishment New York Stock Exchange (NYSE). A “market-maker” is nothing more than a middleman who acts as an intermediary between people that want to buy and sell stock, sort of like Ebay or a stamp shop. That sounds pedestrian, but it was historically a very important part of the stock market. If you called Merrill Lynch to sell your shares of a small-cap stock in the 1970s, your broker turned around and sold it to people like Bernie Madoff. If you wanted to buy that same stock, then the broker called Madoff, too.
Stock dealers like Madoff formed the NASDAQ exchange in 1971 as a scrappy rival that specialized in companies that were too small or “too risky” to qualify for listing on the NYSE. NASDAQ grew over time, in part because some of its small risky companies, like Microsoft and Apple, stayed on the exchange after they became big and powerful. Madoff served as chairman of the board of NASDAQ and was viewed by the Security and Exchange Commission (SEC), the main federal regulator of the stock market, as a responsible Wall Street citizen who could help it in its mission to protect investors and markets.
This is all a fairly normal Wall Street story – scrappy upstart makes a nice living as a market-maker – but then it gets weird. Madoff started running an investment fund with money funneled to him by a small accounting firm on Long Island that served a largely Jewish clientele. Clients would send Madoff money, he would ostensibly invest it, and he would send them back monthly printouts of how their accounts steadily grew at 1 or 1.5 percent per month, month after month and year after year. The investors’ returns seemed to be excellent – and so stable, too! – so most of them left their money with Madoff and told their friends to invest with him, too. Madoff would play hard to get with those newbies, always making it seem like he was doing them a favor to manage their money so well.
But Madoff wasn’t investing any of the money! He was simply depositing the incoming money in a checking account at Chase Manhattan that paid no interest, meaning that the high, steady returns were, over time, backed by a small and dwindling pile of cash. The statements that Madoff sent off each month? They were a fiction, a list of fake trades contrived after the fact to produce the desired level of returns. Clients could not log on to their account at Madoff nor could they direct Madoff to trade any particular stock or fund. It was all very weird but, with the high reported returns, few complained or withdrew their money. Madoff kept enough cash around, after his thefts, to pay off the few who sought redemption.
Madoff thus came to run two separate businesses on nearly adjacent floors of a fancy east Manhattan high rise. There was the legitimate market-maker business where his two sons worked and, two floors below, there was the investment advisory firm that was running the biggest Ponzi scheme in history. The only person who went back and forth between the two floors was Madoff himself. He enlisted a few people to help him run the Ponzi scheme, typically smart but unsophisticated young people who could be convinced that a long-running fraud was just how the business world worked. Any concerns they might have had were mollified by the high salaries that Madoff paid.
It’s not easy to run a Ponzi scheme. People occasionally ask for their money back and, since Madoff had been lying about the returns, there wasn’t enough cash to pay them back unless new investors kept bringing in new money. He had some close calls when redemption requests almost depleted his cash – but he would bully away some prospective withdrawals by telling his accountholders that he would never let them back in if they left for even a minute. Madoff kept it going for nearly thirty years.
There are no real villains in the stories other than Madoff and his underlings, but there is plenty of incompetence. Most of the investors were incompetent to evaluate Madoff, save for a few people that recruited investors to his firm (for a fee) and who really should have known better….and perhaps did. Many of the investors trusted Madoff as a fellow Jew, leading to a form of “affinity fraud” in which criminals take advantage of others’ in-group trust. Others were excited about the thought that they had gotten in on a good deal not available to standard investors, encouraged in this view by Madoff’s regular entreaties to not tell anyone else about what great returns they were getting. While they varied in their motivations, all of the bilked investors failed to listen to the wise old adage that “If it’s too good to be true, then it probably isn’t.”
The one person who saw through Madoff was Harry Markopoulos, an aspergery investment manager in Boston who you do not want sifting through your misdeeds. Markopolous’ bosses charged him with designing a product that would compete with Madoff, hoping to draw away some of Madoff’s business, but Markopoulos quickly realized that the high, steady returns that Madoff reported were literally impossible. Year after year, Madoff claimed to pile into a stock days before it boomed and to close out his positions right before they crashed. Madoff was either a genius or a fraud, and Markopoulos didn’t think he was a genius. Markopolous sent the SEC calculations proving that Madoff was a fraud, but they blew chance after chance to properly investigate Madoff’s business…..and so Madoff continued to collect and waste hundreds of millions of dollars of his clients’ money.
I find it hard to understand Madoff’s motivations. He had a successful, legitimate business – his market-making operation – and so why did he feel the need to develop a second, fraudulent business? It’s very puzzling. I think that part of the reason is that Madoff saw little difference between the two, which is to say that he thought his legitimate business was also a fraud, that the trading of stocks and other financial assets was purely a dog-eat-dog enterprise in which some people won and other people got screwed. There was no intrinsic value to his market-making business, his financial Ebay, and so why not rip people off in other ways, too. Sure, the second business was illegal while the first was not, but that didn’t matter to Madoff – the whole industry was a corrupt rat race.
The sad thing is that so many people agree with Madoff about the fundamental uselessness and corruption of the finance industry. That’s sad because the finance industry is actually very important and, for the most part, it’s not run all that badly. It’s a minor miracle that I can deposit my money with a bank or broker and then, years later, have a reasonable expectation that, rather than ripping me off, they will return my money with interest. That’s much better than having to store my wealth in jewels, gold, land, or livestock - some of the few ways that our ancestors had to store wealth – because those alternatives are both vulnerable to theft and difficult to diversify. Yes, money gets lost or stolen in the financial system, but the risks are generally much lower than they were back before there was a finance industry.
It’s a particular miracle that the American finance industry is largely run without family connections. The idea that we can trust somebody other than an uncle or sibling to watch after our money is a new one – the banks of renaissance Florence and Amsterdam, for example, were largely run among families or narrow ethnic groups. Americans value individualism but, as Francis Fukuyama has shown, Americans are simultaneously quite willing to trust non-relations with our money and our health. So the incredible thing is not that Madoff ripped off some investors, it’s that Americans (and some other countries) have built a system in which that kind of thing is rare.
The finance industry is also important because it directs the distribution of capital. We give banks and brokers our money, and then they go and invest that money in new projects – apartment buildings, car factories, medical research, etc. The better their choices, the wealthier we’ll all be in the future. It’s an important task and, by and large, the private finance industry does a respectable job, in part because they are financially motivated to do so. We shouldn’t take this for granted! The Soviet Union did a terrible job in allocating capital, wildly over-investing for decades in heavy industry that, by itself, did little to improve the lives of its citizens. One of the reasons that its capital was allocated so badly was that there was no Russian finance industry trying to allocate funds to their most productive uses.
Madoff – The Monster on Wall Street ends with ominous warnings that there will be more fraud, more Madoffs in the future, and of course they’re right. There is even just this week the story of the breakup of a Las Vegas-based ponzi scheme that catered to unsophisticated Mormon investors who thought they were getting in on a special deal from a co-religionist. But my forecast is that large-scale financial frauds will continue to be rare and that, relative to stuffing cash in your mattress or diamonds in your safe, the financial industry will be the best place to park your savings, both for yourself and for the broader economy.
Madoff wouldn’t buy anything of what I just said. To him, the finance industry merely reallocated slices of the pie from one greedy pig to another; there was no value in letting people save their slice of pie for later, and wise investment policies didn’t make the pie any bigger. If it’s all a fraud, he thought, then he might as well be the biggest fraudster of them all – he’d be a chump to do otherwise. I think that’s a shame, not just because of what it ultimately did to Madoff, his sons, and his clients, but also because it’s ignorant nihilism. Done well, finance is honorable and important work, and we’d all do well to keep that in mind now and again.
Good article, Will, as always! For a somewhat less sanguine view of the relative rarity or frequency of financial fraud, manipulation, hucksterism, insider dealing, and general insanity in the field of finance, I find Matt Levine’s “Money stuff” to be a daily source of enlightenment and entertainment. Not on the scale of Madoff, but still…
I'm going to assign this as a reading for my Principles of Macro class next time I teach it. I go on and on about how finance is important, but you explain better than I do. (I use a dating app analogy. Wall Street matches people who have temporarily have too much money now relative to later with people who have companies they want to build but don't have the cash to do it.).