Inside the mind of Bernie Madoff

How did a prominent Wall Street entrepreneur, known to all the powers that be in New York and Washington — including regulators — get away with what he says was a $50 billion Ponzi scheme?

Now that the first wave of shock regarding Bernard Madoff’s activities has passed and people have expressed their disgust and rage with Wall Street, regulators and, of course, Madoff himself, a universal and unanswered question remains: How did he pull it off?
I’ve written about how Bernie came off as a cool guy, but he certainly isn’t Wall Street’s smartest guy or even, from past evidence, its most devious guy.
Which begs the question: How did a prominent Wall Street entrepreneur, known to all the powers that be in New York and Washington — including regulators — get away with what he says was a $50 billion Ponzi scheme?
I have a theory.
Bernie, above all, is a trader. In the old Nasdaq market-maker days, that meant skimming eighths of a dollar from every trade. To paraphrase Sen. Everett Dirksen, an eighth here and an eighth there, and pretty soon you’ve got a lot of money. Payment for order flow was another nifty way for market-makers to pocket slivers of trades that added up to mansions’ worth of dough over time.
I believe that this nickel-and-dime way to wealth — or the 12-and-a half-cents route, to be more precise — shaped Bernie’s thinking. I bet that, in the beginning, he treated his investors’ money like his firm’s capital, and, under most market conditions, he was able to generate a nice return simply by capturing the dealer’s spread or by profiting from the trading insights that come from sitting in a dealer’s catbird seat.
Then the game changed.
Nasdaq market-making came under scrutiny and was exposed as a price-fixing mechanism. Then came twin calamities: decimalization, which further sliced spreads, and the bursting of the tech bubble. Even if Bernie wanted to make money the old-fashioned way, he couldn’t. So he began to engage in what I call “fractional investing.”
Like fractional banking, in which only a few pennies of every dollar on deposit actually stays at the bank, with most going out as loans, fractional investing assumes that only a few investors will actually want their principal returned to them at any one time.
I believe that when Bernie’s market-making activities no longer generated the needed level of real returns for his investors, he simply paid the difference from the new money coming in.
A Ponzi scheme? For sure, but also “fractional investing,” in that most of the money probably was used to buy and sell securities, with only a small share skimmed from new investors to pay old investors.
Bernie probably believed that when the market turned around, he’d be able to make up the shortfall and no one would be the wiser. After all, he was a trader, and that’s what always happened. And even if the market were to stay in the doldrums, so long as he could produce modest returns, investors wouldn’t yank their principal.
But when the market collapsed and too many investors began demanding their money at once — like the bank run at Jimmy Stewart’s building and loan in “It’s a Wonderful Life” — Bernie was cooked.
Suddenly, in Bernie-land, there was no there, there.
That’s my supposition, and I hope that the SEC, Finra, the New York attorney general and whoever else is looking into Bernie finds out what really happened.
I also have a hunch that, unless those around him were in some sort of self-induced coma, they had more than an inkling of what was going on.
Don’t you think it’s time that the regulators found out what exactly went on?
It’s time for Bernie to pay the piper.