Wednesday, December 24, 2008

The Madoff Ponzi—Where did all the money go (and what does this have to do with our fiscal deficit)?

It is difficult not to wonder about this. When I discuss the matter with my friends, the inevitable point is made that it is really hard to spend $50 billion dollars, even over a 10-15 year period. So where did it all go and what does this have to do with our fiscal deficit? My son Nate, who is an MBA student at Yale, and I were recently discussing these questions and the following is our fairly arbitrary guess. Our estimates are, of course, just conjectures. At some point, investigators will probably be able to come up with a far better estimate, and it will be intriguing to really disentangle this complex scheme.

Several observations on the mechanics of such a scheme can be imagined. First, one must assume that some of the capital simply went to support Mr. Madoff and his life style of an apartment in Manhattan, fancy houses in Montauk and Palm Beach, and if I recollect from the news, a house or apartment in Europe. I also seem to recall yachts with the name of “Bull,” as well as country club memberships in Palm Beach and the Hamptons. All of this does not come cheap, and one may assume that Mr. Madoff pocketed and spent, after tax, at least $25 million a year—or $35 million pretax-- (my ignorance of this standard of living may mean that I have underestimated what such a life style costs by a factor of two or three even). But there is also significant overhead to the production of Ponzi income of this magnitude. Add three floors of rent in the so-called Lipstick building of Manhattan, as well as the overhead costs of the employees and other running costs of his legitimate securities transactions business (presumably including at least two well-paid sons and other relatives), and we can potentially account for another $40 million in expenses (again, my numbers are completely arbitrary). So this would imply that Madoff would have had to have annual inflows of capital to his operation of at least $75 million to cover these costs. Even over 10-15 years, this would have amounted to no more than $1-1.2 billion. But when the scheme collapsed, Madoff estimated that something like $50 billion was the amount of lost capital, leaving us with approximately $49 billion unaccounted for.

So what happened to the rest of the money? Let’s look at how the scheme would have worked in a given year. Let us imagine 2008, this last year of the scheme before it collapsed. At the roughly 10 percent rate that Madoff was offering investors, he would have had to pay out about $5 billion in “dividends and interest” in order for his investors to continue as happy campers. Simply as a guess, let us assume that 60% of the

$5 billion, or $3 billion, stayed with Madoff as a reinvestment and 40% was paid out and spent by his investors. For the latter, this would have included the charitable foundations that paid their employees and made grants with the income; the universities that used this endowment income to pay their teachers and staff; and of course those who lived on their income from Madoff to support their retirement or their life style of consumption. Assuming that Madoff was running the operation with no liquid reserves, this implies that Madoff would have needed roughly $2 billion in capital inflows plus at least another $75 million, as noted above, to cover the payout to investors as well as his own “expenses.”[1]

Including the inflows from new investors (which were added, on paper, to Madoff’s principal even though he was actually using the money to pay off existing investors) to the $3 billion Madoff was supposedly reinvesting, the capital value of the Madoff scheme would have risen by the full $5 billion in 2008, even with zero increase in actual value ($2.1bn in from new investors, $2.1bn out for expenses and payouts, $3bn of fictitious returns). It is also worth noting that Madoff’s reported earnings attributable to investors would have been subject to taxes by their recipients.

Of course these are the figures at the end of the scheme. During all of the previous years, a similar type of operation was occurring, with some of the money being paid out and actually used for real purposes by Madoff’s clientele, and with an important part of the capital growing fictitiously. So in trying to guess where the money went, one might hazard the fairly arbitrary guess that a significant part (perhaps 65 percent) never went anywhere! It represented earnings on capital, reinvested, that never actually existed. It was as if the original money of investors had not been invested but spent, but nevertheless the original sum was kept on the books and a 10 percent return kept being added to it.[2] (Note that if you were to invest $100,000 and earn a 10 percent return that you reinvested every year, you would have roughly $260,000 accumulated at the end of 10 years). So one can easily imagine that if many investors had left their money in the investment scheme for many years, quite a significant fraction of the amount they supposedly held would have simply been the result of smoke and mirrors.

Another significant sum, let us say roughly 30-35 percent, was actually was paid out and used by legitimate people for presumably legitimate purposes. A small share, probably 1 percent, was earned as fees by the feeder funds that took a 1.5 percent management fee on the amounts that they channeled to the Madoff funds. Madoff and his enterprise probably skimmed off about 1-2 percent of the total over the years. As is inevitable with Ponzi schemes, those who invested late in the game were probably the largest losers, never having had the opportunity to avail themselves of the income that Madoff so regularly paid out.

And how does the fiscal deficit enter in? Well, as I noted above, for each $1000 reportedly earned by Madoff for his clientele, at least $150 was presumably paid to the Federal government in taxes (assuming all of it was declared as dividends and subject to the 15 percent tax rate on dividends). However, in many cases, even more was probably paid, since some earnings would have been declared as interest and taxed at the recipient’s marginal tax rate. Most likely, the Federal government received, on average, about 20 percent of Madoff’s fictitious reported earnings for his clients. So most likely, if roughly $47-50 billion was “earned” over the time frame of the Madoff scheme, and this was all declared as taxable income, the Federal Government was probably the beneficiary of about $10 billion. So one could say that this was Madoff’s implicit contribution to preventing the Federal deficit from being even higher over the period. Of course, now that the losses are revealed, it is likely that many of the losers will now be able to write off some of their losses, recouping some of their previous payments in lower tax liabilities in 2008 and 2009, and thus adding to the already high fiscal deficit!

None of this is very pretty as we begin the holiday season.

[1] Most likely, during some years of the operation, Madoff did have liquid reserves which he invested and actually earned some income from; in this last year, one might imagine that capital withdrawals exhausted these reserves and that he was frantically seeking new inflows to cover withdrawals as well as his normal payout to investors at the time the operation collapsed.

[2] One should also note that from the perspective of these investors, the real loss in return is what they would have earned if they had invested in legitimate securities, with the rest of the loss wholly fictional, representing an unreal, above-market return.

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