Video: Red flags on Ponzi scheme

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updated 12/12/2008 1:41:58 PM ET 2008-12-12T18:41:58

For years there were whispers on Wall Street about Bernard Madoff’s hedge fund. The cynics said the returns were too good, too steady and Madoff’s operation always looked too slim for the tens of billions of dollars it was managing. But given Madoff’s more than four decades of experience as trader and past service as chairman of the Nasdaq stock market, the wealthy kept giving him their money.

Well, it looks like those concerns were right all along now that federal prosecutors have charged the 70-year-old Madoff with securities fraud in what could amount to one of the biggest Wall Street scams ever. Securities regulators, in a civil complaint, say Madoff’s scheme may have cost investors up to $50 billion. At a minimum, it appears the $17 billion Madoff was managing earlier this year may be gone.

The allegations against Madoff describe a classic Ponzi scheme, in which money is taken in from new investors to pay out money to earlier investors. Madoff, authorities allege, even told his sons earlier this week that the hedge fund was nothing more than “a giant Ponzi scheme.’’

It didn’t take long for investors in Madoff’s fund to begin crying foul. Hours after the news of Madoff’s arrest broke, investors were contacting lawyers to determine how they can get their money back — assuming there is any money left over. The Securities and Exchange Commission is moving to appoint a receiver to take control of the Madoff fund to protect whatever assets remain.

It’s way too soon to know how long the alleged scheme had been going on, although authorities allege it began years ago, after Madoff tried to cover up for past losses. But it appears Madoff ultimately was unmasked by the worst financial crisis since the Great Depression. Just like many hedge fund operators, Madoff received a wave of redemption notices in recent months, from investors looking to preserve cash. Authorities say investors sought to pull out some $7 billion from the fund — money Madoff apparently did not have. In the end, most Ponzi schemes collapse when too many investors seek to pull their money out at the same time, and the operator doesn’t have the cash on hand.

But the financial crisis appears to be hastening that unwinding process, as it has dried-up all sources of liquidity. Banks are unwilling to lend and investors are fleeing hedge funds, stocks, bonds, commodities and other asset classes for the safety of cash. In September, another alleged Ponzi scheme collapsed, when federal prosecutors arrested Minnesota businessman Tom Petters. Federal prosecutors allege that much of Petters’ empire, which consisted of buying up distressed businesses, was based on a series of lies. He’s been charged him with bilking some six dozen hedge funds out of $3 billion. Petters’ alleged scheme came undone when some of the hedge funds that lent him money had gotten redemption requests from their investors and began asking Petters to pay off his debt. Just like Madoff, Petters apparently couldn’t come up with the cash.

A lack of liquidity may have been behind the bizarre scheme involving New York attorney Marc Dreier. Earlier this week, federal prosecutors charged the high-profile attorney with allegedly scamming several hedge funds into giving him up to $100 million by selling shares in what appears to be a fraudulent real estate venture. It appears Dreier’s 250-lawyer firm was running low on cash and had failed to make payments on a bank loan.

As the financial crisis deepens, don’t be surprised if other scams get flushed out in the coming weeks and months.

Copyright © 2012 Bloomberg L.P.All rights reserved.

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