Thank God It Was $65 Billion

When Bernie Madoff turned himself in, his firm owed investors $65 billion, but had only about a billion dollars on hand. Never before have we seen anything close to a $64 billion fraud. But in an important sense, the unprecedented vastness of Bernie Madoff’s fraud is a good thing.

“If I hadn’t invested in Madoff, I would have ended up with less than $5 million.”

Its sheer size guarantees that most of the money was not consumed by Madoff’s friends and family. It is exceedingly hard to consume even a billion dollars during your lifetime. You can burn through tens of millions, yes. But tens of billions, no.

In small cons, the crooks can skim off and eat up a substantial part of the investments. The blaggard Charles Ponzi diverted more than two-thirds of investments to his own use.

Madoff’s inability to eat all that he stole is good news because the social costs of the scam are much less than they might have been. It also seems that he didn’t waste investors’ money on imprudent investments. Indeed, he may have made virtually no investments, keeping the money in cash so that it could be paid out to early withdrawers.

The $64 billion must crudely fall into three different buckets. 1) some of it may have been diverted into secret bank accounts; 2) some of it is merely paper losses of claimed gains that never existed; and 3) some of it was transferred to innocent investors who chose to withdraw some or all of their gains early.

Each of these buckets has a bit of a silver lining.

First, any money that Madoff diverted into secret accounts still exists. The good news is that with hard work from the investor trustee and cooperation from the international banking community, this money can be reclaimed to compensate Madoff investors. (And Bernie’s friends and family don’t have much use for a secret $10 billion that they will never be able to spend.) The government has already moved against Madoff’s personal assets which in 2008 were estimated to be over $800 million. Money was openly paid as fees to feeder funds, who may have turned a blind eye to Madoff mischief, but are likely to have to disgorge their compensation to compensate Madoff investors.

Second, let’s consider the paper losses. They are a heartache. If I had invested $1 million with Madoff and thought it had grown to $5 million, I would be devastated to learn that I suddenly had nothing. I might have relied on that $5 million for my retirement while spending down the rest of my assets.

But from another perspective, I’ve lost a lot less than $5 million. If I hadn’t invested in Madoff, I would have ended up with less than $5 million. Indeed, the recent collapse of stock prices in some ways mitigates the harm of Madoff’s mischief even more. If I hadn’t invested with Madoff, I might very likely have invested with some other hedge fund that took a beating this last year. Maybe Madoff only made me lose half a million.

That doesn’t mean investors’ psychic and reliance costs are illusory; but it does mean, looking cash-on-cash, that the lost paper profits far exceed the losses to initial investments that investors would have experienced if they had never heard of Bernie Madoff.

And finally, let’s consider the money that was transferred to Madoff investors who withdrew some or all of their funds before the collapse. These innocents were the unwitting beneficiaries of the scam. Indeed, it is almost certainly the case that the money transferred to Madoff investors was orders of magnitude greater than the amount transferred to Madoff and his henchmen.

This means, from a social perspective, that the Madoff scheme was a huge transfer of assets among innocents. And because Madoff kept the money almost exclusively in cash, and took so little off the table for himself, it was — compared to probably any other fraud in history — an incredibly efficient transfer.

We might end up clawing back some of the Wall Street executive bonuses paid out during the past few years, but it is unlikely that the law will claw back any of the exorbitant returns earned by early-withdrawing Madoff investors. It seems kind of unfair that some Madoff investors get to walk away with a 15 percent annual return and others with a 100 percent loss. But under our legal system, in a fight among innocents, that’s usually the way the cookie crumbles.

It will be interesting to learn who got their money out early. Think for a minute about which types of investors were likely to withdraw early. To be sure, some would be retirees who needed to start living on the money (although many of these would have let it ride to give to their kids upon death without paying capital gains). You wouldn’t think that many people still saving for retirement would withdraw early; they’d want to keep riding a winner.

No, I’m thinking we will ultimately learn that some charities — especially those with smaller endowments — were most likely to withdraw their returns as they accrued to help pay current operating expenses. This is just rank speculation, but at the end of the day, nonprofit investors may have been net beneficiaries of the Madoff scam. To be sure, Madoff decimated charities that woke up one morning with no money at all. But a chance to get a 20 percent return on your money for 10 years (even if you never get your principal repaid), can be a lot more lucrative than just earning ordinary market returns.

The big picture is still one of devastation. The Madoff scam on net is likely to have done more total damage than any other fraud in world history. Even if most of the scam was a transfer among innocents, this was not a lottery that any of them signed up for. But this fraud is also exceptional because the Madoffs’ vigorish on a percentage basis was so exceptionally small.

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  1. Randolph says:

    Great article, with lots of good points. NPR also did a piece where they questioned whether the news media should be referencing it as a ‘$65 billion fraud’. They took a more extreme version of the fraud to highlight the problem. What if someone promises to take ten dollars from you and turn it into a billion dollars? When you lose your investment, should the media refer to it as a ‘billion dollar fraud’?

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  2. Joe Smith says:

    One thing you did not mention is that some of the money was paid out as taxable distributions when in fact they were return of capital. Some part of the $65 Billion is going to come back to investors from the treasury when the investors recalculate their taxes.

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  3. Trevor L says:

    I’m pretty sure your assessment of the non-profit organizations is untrue. Most, if not all, of the charities used their Madoff investment as an opportunity to make their endowment look good and constantly growing. If a non-profit needs to dip into their endowment, the one place it won’t touch are the investments which are constantly accruing money. By leaving those investments in the fund, the non-profit can ensure that the debt caused by the money they just took out would be covered by the returns coming in from the Madoff fund. Also, you are forgetting the aura which surrounded the Madoff fund; non-profits figured that if they got into the fund, they struck gold. In an industry where fund raising is difficult (and required) entry into the Madoff fund is striking gold.

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  4. Hmmmmm says:

    I have a hard time believing that money was not being laudered thru this scheme. That is the only way to account for the missing money.

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  5. David A.M. Wilensky says:

    The big loser here is the Jewish non-profit community. I work for a Jewish non-profit in the NY area and many, if not all, of the non-profits that invested with Madoff were Jewish organizations. We’ll be feeling this shmuck’s harm for years in this sector.

    The Reform Shuckle:

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  6. econobiker says:

    I also took it to understand that the $65 billion figure is the supposed amounts that the victims thought their accounts had gained, not the actual investments provided. I wish the media could figure this difference out:

    Uncle Solly invested $2million with Madoff.
    10 years later Uncle Solly thinks he has now has $10 million invested with Madoff even while having received $200,000 annual ayouts over the last 10 years.
    Now Uncle Solly thinks he lost $10million, not $2million.

    Also I figure alot of the “non-profits” suffering were/are just charitable trusts that were implimented to funnel profits tax free until the beneficiary’s death or across generations or similar…

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  7. BH says:

    It may not even be possible, but someone needs to calculate the net inflows minus the net outflows from the fund. This is the true cost of the scandal. For many of us non-Madoff investors that have stayed in the market, we have seen a near-zero return over the last decade or so, so including zero return is not a stretch.

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  8. Chris S. says:

    I agree with your position that “most of the money was not consumed by Madoff’s friends and family.” And I agree with your main pont that the $64 billion is largely illusory as there were virtually no investments made at all.

    However, I profoundly disagree with your implication that there is some sort of silver lining to the fact that Madoff was stealing (he certainly didn’t earn any of his money) a smaller percentage from an extremely large pile of money.

    I think it is more appropriate to focus on the amount of money Madoff stole for himself and his family rather than the percentage of holdings he stole. Ponzi may have taken a larger percentage, but he had far smaller holdings, and he only operated his scam for a few months.

    While it may be a challenge to spend more than a few tens of millions of dollars in a year, Madoff ran his scam for at least ten years, possibly as many as 40. Several branches of an extended family could well burn through a billion dollars a decade.

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