How Madoff made off with billions

How did a once respected businessman end up in the center of the largest financial scheme in history?

Former businessman Bernie Madoff
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Former businessman Bernie Madoff

Standing in court in his thousand-dollar suit, Bernie Madoff never once looked back at the audience behind him. The irony of the situation must have struck him; it’s pretty ironic, after all, that he’s now completely at the mercy of those he scammed for more than four decades.

It was there on Mar. 12 that the former businessman and non-executive chairman of the NASDAQ stock exchange pleaded guilty to 11 counts of fraud, theft, money-laundering and perjury, admitting to having defrauded thousands of investors for approximately $65 billion.

Madoff had pulled off a scam as impressive as it was malicious, leaving investors baffled and giving little explanation for what happened to their most trusted assets.

“When I began the Ponzi scheme, I believed it would end shortly and I would be able to extricate myself and my clients from the scheme,” he told the court. “However, this proved difficult and, indeed, ultimately impossible. And as the years went by, I realized that my arrest and this day would inevitably come.”

All of the case’s factors amounted to one final mystery: how had one man succeeded in single-handedly pulling off the largest case of investor fraud ever seen in the United States?

Madoff’s scam relied on the basis of a simple Ponzi scheme, a fraud in which investors are promised high returns from owning shares in a confidential investment.

Gregor Smith, a professor in the Queen’s economic department, said the subscriptions investors paid weren’t invested in stocks.

“Instead, early investors in the scheme who wish to cash out simply are paid back, with interest, from a pool of the subscriptions of later investors,” he said. “Keeping the same scheme going thus relies on an ever-growing pyramid of investors.” The scheme wasn’t an obvious hedge fund—pools of savings that can invest in a wide range of assets, often restricted to investors with certain characteristics, such as those who can afford very large contributions, and was consequentially less regulated than other pools. It also didn’t seem to measure up to the immensity of the dot-com bubble craze when, Smith said, investors purchased assets even if they didn’t think they would pay dividends, expecting the price to keep rising as others shared the same view. The investors then simply tried to sell their holdings before the bubble burst, causing a sharp drop in the prices of these stocks.

“A hedge fund is actually a misnomer. In practice many hedge funds do not hedge but actually take on extra risk by borrowing from banks to make even larger and riskier investments,” Smith said.

In their article, “How Bernie did it,” Fortune magazine editor at large James Bandler and senior writer Nicholas Varchaver decode the bizarre intricacies of Madoff’s massive swindle.

Bandler said Madoff lured his clients into a false sense of security.

“I think people who are seeing such wonderful returns year after year have a remarkable capacity to suspend disbelief,” he told the Journal. “There have been other media reports stating that some investors believed Madoff was front-running, which would be illegal—and yet they were willing to keep their money with him.”

Madoff created an alter ego for himself, a friendly face with a reassuringly trustworthy air. He may not have been an investing wizard, Bandler said, but he was a master of human psychology.

In his article, Bandler said one of the reasons Madoff was able to perpetrate his fraud for so long was his preference for marketing his investment business by word of mouth.

“One of the most powerful lures was Madoff’s exclusivity. … There were times when he refused to take more money from some of his biggest investors,” he said. “Such limits, combined with the fact that the performance on an annual level at least, didn’t seem all that remarkable, compared with say, dot-com bubble mania or many hedge funds, making people think it was impossible this guy would cheat.”

Bandler said he’s never interviewed Madoff and is hesitant to speculate on his thought process, but interviewed several people close to Madoff and his family to find out what made the patriarch of the family business tick.

“One person we interviewed, a longtime family friend of the Madoffs, told us that she thought that Bernie Madoff and his wife Ruth had bought into their own myth,” he said. “He spent decades being venerated as an investing genius; it would not surprise me at all if he came to believe it.

“Another source, who worked with Madoff for decades, suggested that the fraud was based in ego: That Madoff began a legitimate investing business, suffered reversals and couldn’t bear the shame of having to acknowledge failure. Indeed, the latter is more or less what Madoff himself said in court.”

Despite the worldwide media blitz surrounding Madoff’s scam, Bandler said future investors probably won’t learn a lot from this incident.

“There have been charlatans, scammers and scoundrels throughout history. Madoff may have been the biggest ever, but he was far, far, far from the first,” he said. “Perhaps investors will be more on their guard for some period of time, but the truth is this is much more about psychology than finances, and the great con mans have an ability to tap into non-rational psychological factors. That’s the definition of a ‘confidence man.’”

Madoff will be sentenced on June 29, where the 71 year-old could face up to 150 years in prison. Regardless of the outcome, it is unlikely that Madoff will step foot on free soil for the rest of his life.

“It is very difficult to speculate on how Madoff feels about [his punishment]. I suspect that he is feeling some relief that a major burden has been lifted,” Bandler said. “That said, he led a charmed and wealthy life for many decades and I think that no matter how you slice it, the shame and stark conditions of his present situation have to be tough on him.” Unlike Charles Ponzi before him, Madoff has chosen to face his crime, perhaps attempting to preserve whatever dignity he may have had left. Ironically, dignity may have been the glue that held his facade together for so many years.

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