Monday, December 29, 2008

This is interesting. A few years ago I read a great thriller by Thomas Perry in which a character involved with the Savings and Loan frauds has to run away and hide. Perry does a darned good job of explaining just how too much money looking for too much return on investment creates a climate ripe for fraud of all kinds. In this article a journalist does the same thing with Madoff's fraud, exploring the way the vast sea of "charitable" money (itself generated, perhaps, by the same inflated, bubble market in real estate, securities, and salaries that is now dissolving) created a ripe solution for an almost bacterial level of fraud. I can't find the appropriate cites but I think as we dig further into the failures of the Bush years we are going to see a lot of interconnection between the lax regulation of CEO pay, the bizarre deference to inherited wealth, the convoluted tax laws aimed at charitable donations, the vogue for setting up "family trusts" to handle what seemed like excess familial wealth and this and related fraud schemes.
Regulatory failures surely played a role in Madoff's longevity - the chairman of the Securities and Exchange Commission has apologized and promised an investigation into how examiners missed years of flaming arrows pointing toward Madoff.

But that doesn't explain the structural "success" that Madoff enjoyed for so long. One possible answer is that years ago Madoff solved the two interlocking puzzles that usually prevent Ponzi schemes from becoming perpetual money machines: sustaining growth while maintaining stability...

Some observers have theorized that Madoff's apparent soft spot for foundations was a ploy to instill confidence in private investors. ("Look at all the good work he does for such fine groups!") That might be true, but it overlooks a simple fact that makes foundations ripe targets for a Ponzi schemer: the 5% payout rule.

Federal law requires foundations to spend 5% of their funds each year on good works and administrative costs. ...

By claiming clockwork earnings of roughly 12% a year, Madoff made himself enormously alluring to foundations. They weren't chasing big short-term gains, just a safe and steady haven to cover the 5% payout and grow the base. By satisfying those desires, Madoff attracted gold-plated customers who would enhance his reputation and almost never come running with urgent financial demands. (Nonprofit organizations and endowments aren't governed by the 5% rule, but many operate under a similar slow-and-steady philosophy, and they appear to have been equally embraced by Madoff. Among them was Yeshiva University, which reportedly lost $110 million of its endowment.)

For every $1 billion in foundation investment, Madoff was effectively on the hook for about $50 million in withdrawals a year. If he wasn't making real investments, at that rate the principal would last only 20 years. But by continuing to add new (if more volatile) investments, a Ponzi scheme built on that approach could thrive long into the future. In Madoff's case, it appears that only the autumn market meltdown and extraordinary demands for cash by other investors in early December overwhelmed his well-oiled system.

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