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Former NASDAQ chairman Bernard Madoff disclosed this week that the investment advisory firm he has run (aside from his market making business) was, in fact a fraud.  It’s unknown exactly how much money has been lost, but it appears to be somewhere between $17 billion and $50 billion.

By comparison, think about the money being considered for bailing out the auto makers: $14 billion.

Part of the reason why the entire scam was uncovered was because Madoff posted returns that were quite different from everyone else.

For many years, Madoff reported gains in the vicinity of 1% per month.  In hot markets, sometimes 2% per month.  He rarely (if ever) showed losses.  These numbers (in many years) were “good enough” to attract very wealthy investors.  They weren’t the highest returns, they were not the lowest returns either.  Madoff stated that he managed $17 billion in assets, with somewhere between 11 and 25 clients.  These are some very wealthy clients.

One of the clients happens to be Sterling Equities — a partnership between Saul Katz and Fred Wilpon, who own the New York Mets, along with commercial real estate in the greater NYC area.

Two related events exposed Madoff:

First, the general nervousness regarding the stock market in recent weeks led to requests from his clients for redemptions (they wanted their money back).  A Ponzi scheme tends to fall apart when more than a few people want their money back at the same time.  Madoff received requests to return $7 billion in capital, money which he just didn’t have.

The second event was his own doing: he posted nearly flat returns during recent months, while claiming to be invested in large cap stocks.  By comparison, his peers posted returns in October of -16%.

Something just didn’t add up. As more and more questions were being asked, it became increasingly clear that something was awry.

As the owner of an investment advisory business, I believe it’s important to have a “see-through” business: Mullooly Asset Management does not maintain custody of our clients assets.  Our clients assets are always sitting in an account in your name at a discount brokerage firm — or in your own retirement plan at work.  And regular statements are issued only from the brokerage firm or the retirement plan — not from our firm.

If an investment adviser has custody of the assets (which is what Madoff was doing), it’s really hard to tell where the assets actually are, and how the money is invested.  All you have to rely on are the periodic statements from the advisor.  That’s an enormous amount of trust to place in a single person or firm.  And that is a liability I’d just rather not get involved in — from my perspective, it’s not worth it.

If you’re not familiar with a Ponzi scheme, here’s how it works: you raise money from an initial group of investors, promising to invest the money for them.  You continue to raise money from new investors.  When one of the original investors wants their money back, you take the money from the newest investor and simply “pay back” the original investor…with the newest investor’s money.

The original investor sings your praises — after all, you “invested” his money, grew the money, and then returned the money as promised to the original investor.

Going forward, the word begins to spread about your success.  And, as new investors line up, old investors are paid back and the cycle continues.  Eventually, the cycle ends (typically when too many investors want their money back all at once) and the whole scam is uncovered.  Everyone left in the scam (at the end), winds up losing everything.

You can click here to read an interview from 2001 with this fraud.

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