A new study from UT Dallas shows the ripple effects of the loss of trust in the investment advisory industry induced by the Madoff fraud.
Madoff persuaded more than 10,000 people to trust him with their investments, falsely promising them consistent high returns. When he was caught in December 2008, the investment world was shocked by how he was able to manipulate the system to create one of the longest-running Ponzi schemes in the world.
"There were huge withdrawals," said Dr. Umit Gurun, co-author of the study and professor of accounting in the Naveen Jindal School of Management. "Clients of investment advisers in areas where victims of Madoff's Ponzi scheme were concentrated thought, 'My money is in a fund managed by someone who resembles Bernie Madoff. If Madoff can defraud these investors of their savings, maybe my advisor can too.'"
Gurun said the most important contribution of the study, recently published in The Review of Financial Studies, is to show how large an impact one fraud event can have on the entire financial system.
"It's not just $20 billion that defrauded victims lost," he said. "Such events adversely affect other investors' beliefs in how our financial system works and cause them to lose trust."
The researchers used court documents to identify the victims and their addresses. Data from the U.S. Securities and Exchange Commission provided a closer look at the assets managed by nearly 4,000 investment advisors at 97,000 bank branches in more than 20,000 ZIP codes.
The study found that once the scam was reported, investors who knew Madoff's victims or lived in the same areas lost trust in the financial system and changed their investment behavior.
Those investors pulled $363 billion from their advisors in favor of the relative safety of banks. In turn, many advisors in the affected areas went out of business. Firms with clients in affected regions were more than 40 percent more likely to close up shop.
Two years after the scandal was discovered, the S&P 500 index went up 40 percent, and those who removed their assets from the stock market because of distrust missed out on those returns.
A common factor in the success of a Ponzi scheme is whether an "affinity" link is present between the perpetrator and the targeted victims. Madoff, who is Jewish, targeted mainly older, wealthier Jewish investors. Because this case mainly affected one particular ethnic group, the researchers were able to study how the trust shock transmitted through social networks.
They found the distrust throughout the investors' networks and geographical areas spread by word-of-mouth.
"When people make a good investment, they talk about it. When they lose money, people rarely talk about their mistakes," Gurun said. "A Ponzi scheme is different because you lost money -- not because you made the wrong investments -- but because somebody defrauded you. You might talk about it to warn others, especially those who are in your network. Local media also plays a big role in disseminating the bad news in the local community."
