Madoff's Ponzi Scheme
A Peculiar Irony
By: Bill E. Branscum
Copyright 2009


In the wake of the Madoff case, widely touted as the worst Ponzi investment scheme ever, I am struck by a peculiar irony that nobody seems to have mentioned. It may turn out that investing money with Madoff, and losing it, wasn't such a bad thing.

No, I really have not lost my mind.

We all know what the market has been like lately but, other than the folks on Wall Street, most people don't realize that there were many investments that actually lost more than ninety percent (90%) of their value. The investor who bought $1M worth of stock in R.H. Donnelley (RHD), the publisher of the Yellow Pages phone directories, would have walked away with almost enough money to buy a Happy Meal, and the investor who bet the farm on the recommendation of CNBC's Jim Cramer, putting $1M in CROCS (CROX) shoes wouldn't have fared much better. (CROX) stock values plummeted 95% in 2008. While investing a million dollars in ugly rubber shoes may seem silly, how about a bond insurer such as Ambac Financial Group (ABK). Most people had no idea that the mortgage industry had gone completely crazy, making mortgage-backed securities a treacherous investment. The value of Ambac shares fell 94%.

If an investor was going to lose money in the stock market, the best possible place to have lost it may very well have been with Bernie Madoff. I say that for three reasons.

First, it has been widely reported that the Receiver stands to recover a significant amount of money. Those who invested in Madoff's Ponzi scheme will ultimately have some part of that money recovered.

Second, Madoff was licensed and insured. It has been widely reported that investor losses may be recoverable through the insurance fund created by the Securities Investor Protection Act which covers individual investor losses DUE TO FRAUD up to $500,000 each. The SIPA does not insure against losses due to market fluctuation, no matter how dramatic.

Third, the IRS has published Revenue Rules and Revenue Procedures establishing safe harbor guidelines regarding the application of IRC 165(c)(2) to these cases. Since these will be treated as fraud losses (casualty losses) as opposed to market fluctuation related losses (capital losses), they will be completely deductible.

Compare that to the investor who lost his shirt due to abysmal market performance. That money is gone beyond recovery, there is no insurance fund to pay compensation, and the losses will be treated as a capital loss by the IRS. Unless the investor had significant capital gains to offset, the tax value of a capital loss is nominal.

In the world of investors who suffered cataclysmic losses in the stock market in recent years, the lucky ones are those who entrusted their money to Madoff.

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