The difference between Madoff and the banking system is…?

Still trying to wrap my brain around the notion that one man can go through $50 billion in a Ponzi scheme without anybody noticing, I’ve been pouring through articles about the Madoff Scandal today.*  Reading this stuff is more troubling then I imagined.  For example, this intro to a Dec. 15 article describing what made crap finally hit the fan:

The game ended for Bernard L. Madoff when some of his investors finally asked for their money back. He did not have it, and his suspected Ponzi scheme collapsed.

Could someone explain to me how a run on Madoff’s hedge fund investments is any different then a run on the legal institution everyone uses for savings and checking, banks?  We all know how banks work: We open savings and checking accounts with them, and then they use our money for loans.  They charge interest on those loans, and in turn that interest leads to the money in our accounts (theoretically) expanding.  But the fact is that the money isn’t there.  My savings has been doled out in loans; the bank doesn’t physically have the money.  Sure, there’s no problem when I need to pull a little cash out because it’s just me making a single transaction, but what if everybody tried pulling all their cash out at the same time?

Well, then we have the Great Depression.  But that’s besides the point — fact of the matter is that the money isn’t there.  And that’s the banking system.  It’s legal and this is all general knowledge.

But then we get to this Madoff jerk who burnt through $50 billion, and nobody knew — or would have known — until his investors made a run on him.

Despite the issue of legality here, would anyone care to tell me how Madoff is different from a bank?

* – When not feeding the troll.

13 Responses to “The difference between Madoff and the banking system is…?”

  1. curmudgeonly troll says:

    off the top of my head… banks take deposits, create negotiable instruments like checks… subject to reserve requirements can create money out of thin air by say paying an overdraft… in exchange for various regulations such as reserve requirements, banks can borrow from the Fed to pay cash in the event of sudden demand… bank financial statements are reasonably accurate and are audited by major accounting firms and the transactions reported actually happened …

  2. tas says:

    in exchange for various regulations such as reserve requirements, banks can borrow from the Fed to pay cash in the event of sudden demand…

    I hate to add another “now suppose” point here because, usually when people do that, they run away from the actual point.. But suppose that there’s a run on multiple banks. The notion isn’t too far fetched since, if there’s a panic, it likely won’t be localized to just one bank. What happens to the Feds funds? Sure, they can (and just might) drop interest rates to zero if they want and print more money, but then inflation goes up faster and your money if worth less in value.

  3. DrGail says:

    What I’m not clear about, tas, is whether the $50 billion is the size of the overall fund, or whether that’s how much money Madoff has spent or hidden offshore and therefore cannot be recovered. If it’s the overall fund size, then only a very small portion of that $50 billion would actually be lost. That being the money the very last investors put in. Perhaps you know the answer?

  4. tas says:

    I’ve been wondering about this myself.. From what I gather, he spent he $50 billion. Basically the scheme worked like this: Investors gave Madoff, over the years, a total of $50 billion; he “invested” it and gave his investors returns on their money… But in reality, he was paying for those returns with new money invested into the fund. And it cycled like this for years and years until some investors wanted to pull their billions out of the fund and Madoff couldn’t come up with the money since he never invested it. The money just doesn’t exist.

  5. DrGail says:

    Okay, now that you explain it that way, it certainly suggests that he “made off” (sorry, I couldn’t pass up the pun) with somewhere in the neighborhood of $50 billion, less whatever he had recently collected from new investors and hadn’t spent you and whatever he was holding in reserve in order to pay the “returns” to his investors. Say $41-45 billion.

    That certainly makes me wonder about where it all went. He apparently gave a great deal to charity — or else so many charities wouldn’t have invested their money with him — but I’m pondering whether there are numbered accounts somewhere in Switzerland or in the Caribbean. I can’t even imagine how one could spend anywhere close to $50 billion. Let’s assume he was generous and gave half to charity; what could you possibly spend so much money on?

  6. tas says:

    I think it was spent on the investors themselves — after bonuses for him, his sons, and his employees, of course. But I think the point of this scheme wasn’t to make $50 billion, it was to enrich himself under the illusion of running a highly successful hedge fund. So if a financial institution contributed, say, a billion to the fund, Madoff wouldn’t invest it.. He would take 20% for himself and his company, and the other 80% was distributed to all of his other investors as interest in their “investments”. To give the illusion that Madoff has made all of these profitable investments. Madoff’s objective is seemingly to have made “merely” millions, he just spent $50 billion of other people’s money doing it.

  7. DrGail says:

    I agree that he wasn’t necessarily out to rip off people in order to enrich himself. That’s just so crass. Certainly the illusion of being extremely successful was part of it. I also think (as a psychologist) that some of the thrill for him was being seen as a genius by virtue of his ability to “predict/control” the market well enough to produce very consistent and respectable (and therefore credible) rates of return for his investors.

  8. tas says:

    I disagree — he was out to rip other people off. :) That was the point of his whole scam. Think of his investment fund like a savings account, just with a lot of interest. He keeps sending you the interest, along with a statement saying that your money is still there. Only the “interest” existed, though. So Madoff was ripping off others to enrich himself because he scooped up millions of that money. Millions out of $50 billion is a small percentage, but millions of dollars alone is still a lot of money.

    As for the other factors you mention, posterity based.. Yeah, I can see that as well. Who doesn’t want to be seen as a genius? Unless you’re running for president on the GOP ticket, then people might accuse you of being too aloof to connect with your base.

  9. Steve Ewoldt says:

    tas has the best view so far. Remember this was 50 billion over how many years? But people took money out all the time. He was always able to pay them except for the present crisis. So it will be a long time if ever until someone is able to give a real figure of how much he stole. We only know 50 billion came in. We don’t know how much he paid out over the years. There are other questions, did he ever make any investments? Did he intend to be honest in the beginning? In other words did he just lie when he made bad investments? There is lots of good stuff here that we’ll probably never know, unless he goes to trial instead of just saying “yes, I took it.”

  10. Dr. Bob says:

    Elementary my dear Watson! There’s a simple but VERY IMPORTANT difference. It’s called the Federal Deposit Insurance Corporation (FDIC) which guarantees the government will back investments in the event ot a bank failure or run. Mr. Madoff’s funds were not backed by the FDIC I presume. And of course, the amounts – FDIC only insures up to $100,000, though I think that changed recently.

  11. tas says:

    re: my second comment in the thread where I addressed this.

  12. Steve Skeete says:

    Mr. Madoff is a crook. He is brilliant, smart, and understands how the stock exchange and banking systems work, but all that makes him is a brilliant, smart, educated crook, and these are the worst kind. He is not the first nor will he be the last of his breed.

    Anyone remembers a bank in Gemany that got ripped off by another finacial wizard some years ago? Remember Enron? Etc, etc. Of course not! The world seems to pay very little attention to the misdeeds of these “great” men. I won’t be surprised if a film is made about him after he has spent his obligatory three months under house arrest in his penthouse suite overlooking Wall Street. That is if the matter is not thrown out of court for procedural irregularities.

    My concern is not for crooks like Madoff. These people steal their 50 billion and ride off into the sunset like corporate bandits to live happily ever after. My concern is how does a banking institution that has been around for 150 years suddenly go bankrupt overnight, just like that, taking the houses of thousand of poor people along with it like some economic tsunami.

    But here’s the real trick. Along comes the government and who does it bail out, those poor investors whose life savings got washed away? Of course not lamebrain. It bails out the board of directors of the institution, who along with their bailout billions, get to take home six months salary, millions in bonuses, and guess what, get their jobs back at the same institution.

    I love this free market system! My only regret is not paying enough attention to my maths at schooI. I might have made off with a few millions myself. Man, it is the dream of every African dictator, to bail out with 50 billion, the entire GDP of his country, then go off into exile. Guys like Madoff get to have their cake, share a slice with their lawyers and eat all the rest.

    Who was it that said crime doesn’t pay?

  13. Slumdog Millionarie says:

    Hey Tas,

    Very good Question. I actually googled that same question, which led me here. A shame, for I didn’t see much objective thought on the subject.

    But your sentiments are cause for level headed concern. After all, headlines like this” Former Chairman of the NASDAQ runs 50 million dollar, Modern Day, Charles Ponzi sheme” seem to be too utterly fatuous to ignore… even for us common folk.

    My thoughts are that they are essentially the same… Ahem ..except for the fact that The Banking system and Fed Reserve have Legal and Government Power behind it.

    Here is a NY times article that didn’t seem to get much attention that asks a similar question

    http://www.nytimes.com/2008/12/19/opinion/19krugman.html

    Makes one wonder What our civilized Nation is all about? Oh wait…that’s right…MONEY!

    Best
    J

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