Madoff Case Study: The Largest Ponzi Scheme and Stock Fraud

Bernard Madoff ran one of the world's largest Ponzi schemes and attracted thousands of investors offering them a promise of steadily high returns on their investments. He was arrested for securities fraud on December 11, 2008 by the federal authorities.

This article provides a detailed view of his operations and how he was able to get away for so long.

Whistleblower

Harry Markopolos sent damning material about Bernie Madoff in 2000, 2001, 2005, 2007, and in 2008 to the SEC. None of it led to an inquiry of Madoff’s dealings.

Markopolos was working in an investment firm and Madoff’s hedge fund was their competition. Madoff was a highly respected personality on Wall Street and his client list included famous actors, educational institutions and other seasoned investors. Madoff’s unregistered hedge fund was offering massive returns that no one in the market was able to offer.

Markopolos was instructed by his boss to understand and replicate the trading strategy and revenue streams of Madoff’s hedge fund so that they could replicate it in their firm. Markopolos whose training included calculus, algebra and statistics quickly understood that Madoff was peddling a fraud scheme. He used his mathematical modeling techniques to conclusively prove that Madoff’s scheme was a complete fraud.

Red Flags

Outperforming the market for long

Markopolos noticed that Madoff’s hedge fund’s performance line had a distinct upward trend and very few lows. This was unlike the play of other funds whose highs and lows were more equitable. He suspected that Madoff was either indulging in insider trading or he was running a Ponzi scheme of incredible proportions. He started by suspecting fraud in 2000 but by 2005 he had tracked several red flags that proved Madoff was running a Ponzi scheme.

Revenue source unknown

He realized that for Madoff to offer such high returns and the strategy he said he was using in his trades would have to include buying more options than what existed in the Chicago Stock Exchange at that time. Yet on enquiry he found that no one on the exchange was having a trading relationship with him. None of the big trading houses were doing business with Madoff.

Off the charts Sharpe ratio

He also noticed that the Sharpe Ratio was in the range of 2.5 to 4 for 15 years in a row. This was not the case with any other fund and was extremely unusual. Madoff’s name did not feature in any of the marketing literature. It was later found that he often made investors believe that they were the exclusive few who had access to his magic fund.