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Thank God It Was $65 Billion—A Commentary by Ian Ayres ’86

The following commentary was published in The New York Times on March 23, 2009.

Thank God It Was $65 Billion
By Ian Ayres ’86

When Bernie Madoff turned himself in, his firm owed investors $65 billion, but had only about a billion dollars on hand. Never before have we seen anything close to a $64 billion fraud. But in an important sense, the unprecedented vastness of Bernie Madoff’s fraud is a good thing.

“If I hadn’t invested in Madoff, I would have ended up with less than $5 million.”
 
Its sheer size guarantees that most of the money was not consumed by Madoff’s friends and family. It is exceedingly hard to consume even a billion dollars during your lifetime. You can burn through tens of millions, yes. But tens of billions, no.
 
In small cons, the crooks can skim off and eat up a substantial part of the investments. The blaggard Charles Ponzi diverted more than two-thirds of investments to his own use.
 
Madoff’s inability to eat all that he stole is good news because the social costs of the scam are much less than they might have been. It also seems that he didn’t waste investors’ money on imprudent investments. Indeed, he may have made virtually no investments, keeping the money in cash so that it could be paid out to early withdrawers.
 
The $64 billion must crudely fall into three different buckets. 1) some of it may have been diverted into secret bank accounts; 2) some of it is merely paper losses of claimed gains that never existed; and 3) some of it was transferred to innocent investors who chose to withdraw some or all of their gains early.
 
Each of these buckets has a bit of a silver lining.
 
First, any money that Madoff diverted into secret accounts still exists. The good news is that with hard work from the investor trustee and cooperation from the international banking community, this money can be reclaimed to compensate Madoff investors. (And Bernie’s friends and family don’t have much use for a secret $10 billion that they will never be able to spend.) The government has already moved against Madoff’s personal assets which in 2008 were estimated to be over $800 million. Money was openly paid as fees to feeder funds, who may have turned a blind eye to Madoff mischief, but are likely to have to disgorge their compensation to compensate Madoff investors.
 
Second, let’s consider the paper losses. They are a heartache. If I had invested $1 million with Madoff and thought it had grown to $5 million, I would be devastated to learn that I suddenly had nothing. I might have relied on that $5 million for my retirement while spending down the rest of my assets.
 
But from another perspective, I’ve lost a lot less than $5 million. If I hadn’t invested in Madoff, I would have ended up with less than $5 million. Indeed, the recent collapse of stock prices in some ways mitigates the harm of Madoff’s mischief even more. If I hadn’t invested with Madoff, I might very likely have invested with some other hedge fund that took a beating this last year. Maybe Madoff only made me lose half a million.
 
That doesn’t mean investors’ psychic and reliance costs are illusory; but it does mean, looking cash-on-cash, that the lost paper profits far exceed the losses to initial investments that investors would have experienced if they had never heard of Bernie Madoff.
 
And finally, let’s consider the money that was transferred to Madoff investors who withdrew some or all of their funds before the collapse. These innocents were the unwitting beneficiaries of the scam. Indeed, it is almost certainly the case that the money transferred to Madoff investors was orders of magnitude greater than the amount transferred to Madoff and his henchmen.
 
This means, from a social perspective, that the Madoff scheme was a huge transfer of assets among innocents. And because Madoff kept the money almost exclusively in cash, and took so little off the table for himself, it was — compared to probably any other fraud in history — an incredibly efficient transfer.
 
We might end up clawing back some of the Wall Street executive bonuses paid out during the past few years, but it is unlikely that the law will claw back any of the exorbitant returns earned by early-withdrawing Madoff investors. It seems kind of unfair that some Madoff investors get to walk away with a 15 percent annual return and others with a 100 percent loss. But under our legal system, in a fight among innocents, that’s usually the way the cookie crumbles.
 
It will be interesting to learn who got their money out early. Think for a minute about which types of investors were likely to withdraw early. To be sure, some would be retirees who needed to start living on the money (although many of these would have let it ride to give to their kids upon death without paying capital gains). You wouldn’t think that many people still saving for retirement would withdraw early; they’d want to keep riding a winner.
 
No, I’m thinking we will ultimately learn that some charities — especially those with smaller endowments — were most likely to withdraw their returns as they accrued to help pay current operating expenses. This is just rank speculation, but at the end of the day, nonprofit investors may have been net beneficiaries of the Madoff scam. To be sure, Madoff decimated charities that woke up one morning with no money at all. But a chance to get a 20 percent return on your money for 10 years (even if you never get your principal repaid), can be a lot more lucrative than just earning ordinary market returns.

The big picture is still one of devastation. The Madoff scam on net is likely to have done more total damage than any other fraud in world history. Even if most of the scam was a transfer among innocents, this was not a lottery that any of them signed up for. But this fraud is also exceptional because the Madoffs’ vigorish on a percentage basis was so exceptionally small.