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Wizards of Wall Street, Wizards of Lies

A new book details the anatomy of the Madoff scandal, drawing key lessons for Wall Street investors, regulators and traders alike

Submitted by: Francesca Rheannon

Posted: Sep 13, 2011 – 10:49 PM EST

Series: Book Reviews

Tags: wall street, deregulation, corporate social responsibility, csr, ethics


By Francesca Rheannon

When news of Bernie Madoff’s colossal Ponzi scheme broke in December 2008, it provided a convenient personal focus for the free-floating rage then roiling the American public against Wall Street. It intuitively made the connection between the betrayal by Madoff of his investors and the larger betrayal of “Main Street” by Wall Street.

But Wall Street insiders and the free market punditocracy were slower to make the link. After all, Ponzi schemes are in the class of nakedly illegal frauds that could happen no matter how well Wall Street is policed – all they take are credulous investors, defrauded by a con man. The Madoff scandal, while huge in total dollars ($64.8 billion in paper wealth, including cash losses of about $20 billion), could plausibly be viewed as containing no special lessons about the larger financial system – other than the fall of the latter gave the final nudge that brought down the former.

But in her gripping anatomy of the Madoff scandal, The Wizard of Lies: Bernie Madoff and the Death of Trust, (Henry Holt 2011), New York Times financial journalist Diana B. Henriques connects the dots between the house of cards Bernie Madoff built and the one that toppled on Wall Street in the Fall of 2008:

Madoff’s construction of the biggest Ponzi scheme in history was enabled by the Wall Street he had helped to build. He played a prominent role in shaping the modern market, from computerized NASDAQ trading to the mystique of hedge funds to the proliferation of specious derivatives. He spotted the trends, saw the opportunities, helped write the rulebook, and abetted the weaknesses that we all live with, even now. And he was a creature of the world he helped create, a world that was greedy for riskless gain, impatient with regulation, arrogantly certain of success, woefully deluded about what could go wrong, and selfishly indifferent to the damage done to others.

Although Madoff told his investors they were members of an exclusive club, his fraud fattened on the savings of the middle class as well as the rich. His victims were not just the denizens of Palm Beach, Park Avenue and the French Riviera, but also “construction workers, dental office receptionists, retired teachers, restaurant owners, electricians, insurance agents, artists, writers, chefs, models, therapists, small business owners, modestly successful doctors and lawyers.” (On a personal level, one can only view his family – his sons and his wife especially – as victims on the scale of Greek tragedy.)

Bernie Madoff sits in a medium security facility in North Carolina, serving time on a 150-year sentence. The story he clings to – to this day – is that the fraud began only in the early 1990s. But Henriques suspects it began much earlier—possibly even as early as the 1960s.

That’s when the young Bernie-on-the-make was doing trades on the volatile, go-go “new-issues” market. Americans finally overcame their fear and loathing of the stock market, brought on by the trauma of the Great Depression. Small investors took their money out of banks and looked for brokers who could place it somewhere safe to grow.

Madoff was there to serve them, even though he had to skirt long-established ethical guidelines “by selling such unsuitable investments to his risk-averse clients…Brokers were forbidden to sell their clients investments that were too risky for their individual financial circumstances, even if the clients were willing to buy them. Selling those hot new issues to his clients was wrong, and Madoff knew it.” (An ethic that also went missing in the go-go mortgage market of the aughts.)

His career almost cratered when the hot issues market crashed, but Madoff found a way out. He borrowed $30,000 from his father-in-law to buy back his clients’ shares – without telling them. The fraud wasn’t a Ponzi scheme and he justified it as protecting his investors. But what he was really protecting was his reputation, which swelled when his firm emerged from the crisis unscathed. The “magic” of Bernie Madoff was born.

The inflation of the 1970s eroded returns savers could expect from holding their cash in the bank or CDs. That led investors to a hunger for yield that failed to abate even when the inflation monster was tamed.

A pernicious myth began to take over, that you could have both safety and yield at the same time – a myth tailor-made for a con artist like Bernie Madoff, who lured his investors with steady and robust (but not too robust to arouse suspicion) returns, year after year. Illusory returns, except for those who got in – and out – early.

But who was there to protect Madoff’s marks? “For so many smart but credulous investors, the road to Madoff led through a regulatory no-man’s-land,” the author writes. The SEC had been de-fanged through de-funding; its underpaid staff was churning with excess turnover; and with the election of Ronald Reagan, the wild rumpus of deregulation began. As the lone Cassandra who repeatedly – and unsuccessfully – tried to warn the SEC, a “quant” from the Boston area named Harry Markopolos said, “The SEC is a group of 3,500 chickens tasked to chase down and catch foxes.”

Nor were the other watchdogs any better – the NASD, which was supposed to discipline the NASDAQ, was “flabby…Discipline for infractions was limp and late…For all its technological glitter, the young market was still an adolescent, unruly and resistant to increased supervision. Indeed, one must wonder if Madoff’s firsthand awareness of the NASD’s failings as a regulator encouraged him to think he could get away with his Ponzi scheme…”

But, oh, how the mighty fall! Henriques also tells the fascinating story of the unwinding of the scheme and its aftermath, including the bitter dispute between the “winners”—those who were lucky, or suspicious, enough to take out more than they had invested and the unlucky “losers,” whose principal had vanished into the pockets of the former and those of Madoff’s friends and family.

The lessons she offers at the end of The Wizard of Lies are instructive. For one, she doesn’t put much stock in “transparency” alone:

Inadequate disclosure was not what inflicted the catastrophic losses that so many of Madoff’s victims sustained. What inflicted those losses was their failure even to ask for some fine print, much less read it. What went wrong was their rejection of basic bedrock principles of investing – that high returns are leg-shackled to high risks; that you should never put all your eggs in one basket; that you should never invest in something you cannot understand.

So, on the one hand, as Pogo said, the enemy is us, and our propensity to be fooled by wishful thinking.

But Henriques also sees a role for regulation: “Regulators could designate several large, well-regulated categories of investments as safe for investors – mutual funds, annuities, bank CDs, real estate investment trusts – and then watch those categories like hawks to ensure that no con artists slip in.”

But then she goes further, suggesting that regulation, no matter how strong on paper, is only as good as the robustness of its enforcement. Henriques says mere fines don’t cut the mustard, since “Wall Street makes money like clouds make rain.” Penalties need to carry a real bite – jail time and major career setbacks. Make enforcement strict enough – and Wall Street might just police itself.

Instead, the Street is exerting its clout in Congress to ensure even the weak reforms of Dodd-Frank are rolled back. And they have already had some success.

As markets teeter again on their flimsy foundations, one hopes the lessons of the Madoff scandal find some purchase. The Wizard of Lies should be required reading for all who care about the outcome.

About Francesca Rheannon 

Francesca is CSRwire's Talkback Managing Editor. An award-winning journalist, Francesca is co-founder of Sea Change Media. She produces the Sea Change Radio’s series, Back to The Future, and co-produces the Interfaith Center of Corporate Responsibility’s podcast, The Arc of Change. Francesca’s work has appeared at SocialFunds.com, The CRO and E Magazine, and she is a contributing writer for CSRwire. Francesca hosts the nationally syndicated radio show, Writers Voice with Francesca Rheannon.

For more information on The Wizard of Lies and options to purchase, please visit CSRwire's Books Page.

This commentary is written by a valued member of the CSRwire contributing writers' community and expresses this author's views alone.

Readers: What lessons are still to be learned from Madoff? Tell on Talkback!

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