How to Protect Yourself from the Bernard Madoffs of the World

How to Protect Yourself from the Bernard Madoffs of the World: Ponzi Schemes Revealed

In January 1920, an Italian immigrant discovered an arbitrage potential in international reply coupons - IRC. By purchasing IRCs for stamps in Spain, and then exchanging them for postage in the USA, he could net a profit. Forming a corporation called “Securities Exchange Company”, he decided to raise capital by selling investment coupons with a guaranteed 50% rate of return in only 45 days. Investors lined up. A required $1,000 dollar investment returned $1,500 for a gross of $500. Investors were so pleased from the results that they re-invested their earnings. Over the better part of 1920, approximately 15,000 people invested, and reinvested. Investors used their life savings; homes were mortgaged and assets were liquidated. People continued to reinvest their profits. Money was being made hand over fist. After only 5 months, the Securities Exchange Company had made several million dollars.

Yet the future did not bode well for the company. A financial analyst noted that there simply were not enough IRCs available in Spain for the Securities Exchange Company to be making its profits. Further investigation showed things were too good to be true: no IRCs had ever been collected. Investment returns were being paid out of new investors’ monies. In August, after having taken in tens of millions of dollars from thousands of investors, the man behind it all was federally indicted.

The Italian immigrant was none other than Charles Ponzi. Not only did the scheme’s magnitude make him one of most notorious con men of all time, the scheme also had the dubious distinction of being named after him. Since the 1920s, many have attempted to reproduce the initial success of Charles Ponzi. Most recently, Bernard Madoff, a trusted and respected securities official, was accused of operating a Ponzi scheme.

The Scheme Revealed

Here’s how a Ponzi scheme works:

1. Investors buy into a new investment plan, usually something obscure, complex, or a secret, which generates a very high rate of return.

2. A portion of the funds is used to pay out the returns, which are usually reinvested.

3. Word of mouth about the success draws new investors at an increasing rate.

4. Eventually the scheme must collapse; since the money is never actually invested, there is nothing to cover the returns.

Madoff’s Scheme

Madoff’s Ponzi scheme was based on a false tactic of using stock option puts and call options to garner small gains that accrued rapidly. Using the prestige of his position to gain access to an elite clientele, he promised them moderate yet consistent gains (10%) via a strategy too complex for outsiders to understand. This extended the duration of the Ponzi scheme over a much longer period than most until its collapse in December 2008. It is possible that Madoff executed the largest financial fraud in the world’s history.

As with the original Ponzi scheme, there were warning signs. Analysts attempting to recreate Madoff’s gains by executing similar trades on historical data found it impossible. During a down turn Madoff reported increased gains although overall, the stock’s performance was down by more than a third. Madoff’s accounting practices were questionable and several fund managers advised clients not to invest with him. Despite all these red flags, wealthy investors continued to provide Madoff with millions. Madoff himself estimates the losses to be about $50 billion.

Easy Money at a Price

The thrill of guaranteed money can lure even the most seasoned investors. If it’s too good to be true, it is. Performing a financial analysis of a fund prior to investing large amounts should always be considered, and if it doesn’t seem right, protect yourself and your money. One never knows where the next Ponzi or Madoff is lurking.

Still reeling from the effects dealt by the current economic crisis, the financial sector took another blow this time landing where it hurts most, close to its heart! This was bitter to no end as it points to one of its big boys in the community being the culprit of a fraudulent (Ponzi) styled scheme. The accused is former NASDAQ chairman Bernard Lawrence Madoff and until recently chairman of Bernard L. Madoff Investments Securities, the vehicle he used to siphoned $50 Billion from unsuspecting and clueless investors.

Mr. Madoff’s style of investment baffled and amazed Wall Street pundits for having scored 72 gaining months in a row while posting only 4 months down in 15 years. No one would have ever imagined Mr. Madoff business prowess was nothing less of a dubious Ponzi style scheme character. A scheme named after Charles Ponzi who was responsible for duping thousands of New England residence into investing in a postage stamp speculation during the 1920’s.

Among those investors who fell prey to Mr. Madoff’s worthless scam were:

1.Fairfield Greenwich Group (FGG) - Leading alternative asset investment specialist. Its mission is to offer clients superior funds and related products with a high level of client service and support. This firm has internally managed its own hedge fund and selectively identified external managers for a limited number of close relationship.

2.Banco Santander Central Hispano (STD) - The company offers retail banking and consumer finance in Spain and most parts in Europe. Through its subsidiaries it offers asset management, private banking, corporate and banking investment.

3.Tremont Capital Management - Leader in investment management of hedge fund products and multi-management portfolio.

4.HSBC (HBC) - One of the world’s top bank by assets. It has more than 10,000 offices in 80 countries providing consumer and commercial banking services, credit cards, asset management, private banking, securities undertaking and trading, insurance and leasing.

5.BNP Paribas (BNP) - One of the main bank in Europe. It came about through the merger of Banque Nationale de Paris and Paribas. It offers complete banking services through its branches worldwide.

Questions were once again poised at the financials. Its credibility already tarnished from the credit debacle of 2007- 2008 is repeatedly put on the line as public sentiment is further dampened. An avalanche of queries mostly centering in scam prevention and remedies are to be address with earnest.

1.Due diligence. Done in the same manner as companies do when acquiring targeted companies. This method covers all aspects in relations to the company’s and funds itself.

A.Ask the company’s directors and officers list. It is under the company’s prospectus. Find out who they are and background. How long are they in this business? Are they knowledgeable enough, meaning their education, training and experience are necessary ingredients.

B.What products do they market and how? They should provide you materials, explaining, how they manage funds. This can be found in the company’s prospectus.

C.Historical returns - Ask them for an updated return for several years showing quantity data.

D.Asset Under Management - Get a copy of the fund portfolio, this can be requested from the custodian of the funds.

E.Audited Financial Statement - Both the company and the fund has this statement jot down the name of the accounting firm for they are liable too. Study the statements.

F.Registration Papers - Demand for a copy of the regulatory registration and other pertinent documents for confirmation of its legitimacy.

2.Stay away from high yield fast return scheme. Chances are your money will disappear faster.

3.Stay away from secrecy. Non-disclosure of facts means their hiding something.

4.Always consult a professional. An independent third party who is familiar with fund management can certainly pitch in his 2 cents worth and give you a clearer picture of the fund.

Mr. Madoff did avoid much scrutiny on his funds but a disclosure requirement by clients could have opened some issues on his company like his past SEC investigations. Even if he got away from those investigations, the impact generated as being on a constant SEC query on his company can send signals to investors to stay away from Bernard L. Madoff Investment Securities.

One way to protect against Ponzi schemes is to learn how to tradestock options. Put options can provide “stock insurance” and protect your stock investing positions from large drops. As a stock investingposition drops, the value of a put option increases offsetting the drop in value of the stock.