Were the later rounds of Bernard Madoff investors banking on a bailout?

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Probably not, but it’s an interesting thought:

We argue in this paper that if agents correctly believe in the possibility of a partial bailout when a gigantic Ponzi scheme collapses, and they recognize that a bailout is tantamount to a redistribution of wealth from non-participants to participants, it may be rational for agents to participate, even if they know that it is the last round.

From “The Optimal Design of Ponzi Schemes in Finite Economies,” by Utpal Bhattacharya, Journal of Financial Intermediation, January 2003. (Available for download here.) The paper is about Ponzi schemes that everybody knows are Ponzi schemes, and Bernard Madoff’s investors don’t seem to have had the faintest idea. Although I guess one can never be too sure about that …

What I actually found most interesting about the paper is that Bhattacharya locates his examination of Ponzi schemes squarely in the middle of the broader academic discussion of investment bubbles. It’s another indication that Ponzi schemes are part of a continuum that includes mainstream Wall Street and government finance.

Update Felix Salmon was on this case months ago, and actually got far enough into the paper to see that for Bhattacharya’s model to work, more than half a country’s population had to be in on the Ponzi scheme.

Meanwhile, former Curious Capitalist guest blogger Mark Gimein points out that because of the precedent set in the Bayou Management fund collapse, in which investors who had taken money out before the fraud was exposed ended up having to fork much of it over, Madoff investors who suspected his methods had good reason not to blow the whistle:

The obvious consequence of Bayou is that a country-club friend who’d given his money to Madoff and then gotten suspicious can’t just take his money out and then go to the cops. If he reports his suspicions, he’s likely to be asked to repay any of those 10-percent-a-year “profits” he’d accumulated for a decade.

Update 2 Now Bhattacharya explains himself in the NYT’s Economix blog:

Moral of the story: If you want to design such a scheme and get away with it, make it legal — like investments in subprime mortgages, or investments in energy from water. Then involve as many people as possible, so that it becomes “too big to fail.” Some of the $700 billion bailout money may actually be used to rescue some of your investors.

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