Madoff Scandal: This Could Really Hurt

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Updated from Dec. 11

The Thursday arrest of Wall Street investor Bernie Madoff would be great fodder for playwrights Arthur Miller or David Mamet -- the story of a great American schemer driven to desperation to maintain his relevance as the world passes him by -- except it could do real long-term market damage.

The charges against Madoff are damning. Indeed, the Securities and Exchange Commission characterized the alleged fraud as "stunning" and "epic" in proportion. The former Nasdaq stock market vice chairman allegedly ran an elaborate Ponzi scheme with clients of his firm, Bernard L. Madoff Investment Securities LLC, and did so for years at the loss of some $50 billion.

The news could deal another blow to markets already reeling from a series of blowups that began with the unraveling of two Bear Stearns hedge funds last year. "When the tide goes out on Wall Street, all kinds of flotsam and jetsam are revealed in the mud flats," wrote John Coffee, professor at Columbia University School of Law, in an email to TheStreet.com.

According to an SEC complaint, filed in federal court in Manhattan, Madoff allegedly informed two senior employees that the investment advisory business was a fraud and had been insolvent for years. According to the complaint, Madoff told these employees that he was "finished," that "it's all just one big lie," and that it was "basically, a giant Ponzi scheme."

These senior employees, according to the SEC, "understood him to be saying that he had for years been paying returns to certain investors out of the principal received from other, different investors."

If the charges pan out and he's convicted, it could cost 70-year-old Madoff 20 years in prison and as much as $5 million in fines.

Prosecutors say Madoff ran a quiet investment-advisory business that served between 11 and 25 clients with some $17.1 billion in assets under management. All of those assets, reportedly held at the start of 2008, are now wiped out.

The SEC said it is seeking emergency relief for investors, including an asset freeze and the appointment of a receiver for the firm, which Madoff founded in 1960.

Madoff, who was released on $10 million bail, declined to comment as he walked out of court Thursday. Madoff's defense lawyer Dan Horwitz called the investor "a person of integrity" and said he intends to fight the charge.

Madoff is best known not as a money manager, but as a market maker -- an intermediary who ran a large family business that brokered stock trades between big institutions. That business became less and less profitable as technology and competition brought margins to razor-thin levels years ago. Madoff and independent dealers like him had to pay firms to trade with him instead of going through an exchange.

"His business used a dubious method, but it was state of the art from a technological perspective. I would have to say that I am surprised at the charges as he seemed to have a viable niche in his market," wrote Columbia Law Professor Coffee.

Prosecutors noted that the firm's Web site states: "Clients know that Bernard Madoff has a personal interest in maintaining an unblemished record of value, fair-dealing and high ethical standards that has always been the firm's hallmark."

Former SEC Chairman Harvey Pitt, interviewed Thursday by CNBC, said the scandal would further undermine people's confidence in the securities industry. "It's unfathomable how this could have gone on for so long without anyone having any clue about it," he said. He expects "the likelihood anyone will get any of their money back is slim to none."

Jim Cramer and Doug Kass both likened the potential scope of the Madoff charges with that of Ivan Boesky's insider trading scandal in the 1980s.

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