When did Madoff go from legit to Ponzi?

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One of the big questions that one hopes investigators will dig up an answer for over the next few weeks was when Bernie Madoff’s investment strategy made the switch from legitimate to Ponzi scheme. It seems highly improbable that he meant for it to be a scam from the beginning. There just wasn’t anything in it for him. He was already a pretty wealthy and successful brokerage-house chief. Why endanger that?

No, the progression probably went like this: At first Madoff’s investment strategy—whatever the heck it was—actually did deliver smoothly positive returns. At some point those returns became less reliable, but Madoff opted to keep reporting them as smooth and use good months to make up for bad ones. (Hey, it worked for Jack Welch.) That went okay for a while, but then the market turned against him in a big way and, Nick Leeson-style, he doubled down in attempt to recoup the losses. That didn’t work. But unlike Leeson, Madoff was the boss of the whole operation, so he could keep it going for a few more years as a Ponzi scheme.

When did this switch from return-smoothing to Ponzidom occur? I’m guessing it was sometime around 2001. That’s when Madoff was the subject of a couple of skeptical articles, in the MAR/Hedge newsletter and in Barron’s. He thus had extra incentive to prove those who questioned his unnaturally reliable performance wrong, at precisely the time when, as he told MAR/Hedge, his strategy was least likely to work. From MAR/Hedge:

[T]he split-strike conversion strategy is designed to work best in bull markets and, Madoff points out, until recently “we’ve really been in a bull market since ’82, so this is a good period to do this kind of stuff.”

That was in the spring of 2001, in the early stages of a bear market that would last almost two more years. After that, it’s possible Madoff never again came close to having as much money in his accounts as he said he did, but kept fooling himself that he could somehow earn the money back. This year’s bear market destroyed all hope of that.

It’s a theory, anyway. Or at least a guess.

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