Bernie Madoff ran one of the largest Ponzi schemes in American history and bilked investors of $17 billion in assets, according to court documents. Yet economists at Indiana University’s Kelley School of Business say the real cost is larger than combining the dollar amounts sacrificied by each victim. Due to a loss of trust, investors in communities exposed to Madoff’s scheme moved $430 billion out of risky assets and into bank accounts, the researchers estimate in their paper presented to the National Bureau of Economic Research.

“Trust is important in any kind of economy, but certainly in a capitalist economy,” Dr. Noah Stoffman, an associate professor of finance, told Medical Daily. “And it does seem to be associated with all sorts of good things, including economic growth.” In fact, based on past studies cited in his paper, trust is also associated with the size of firms (and number of paid employees), financial development, and international trade and investments.

Ultimately, this loss of trust in the wake of Madoff's scheme touched the American economy as a whole, says the research team.

A Community Response

Madoff perpetrated his fraud through a registered investment adviser, a type of firm regulated by the Securities and Exchange Commission (SEC). After more than a decade of complaints, Madoff’s Ponzi scheme, which dwarfs more than 360 Ponzi schemes investigated by the SEC in the past two decades, was finally uncovered in December 2008. “Despite having received several tips of suspicious behavior, the SEC did not act until Madoff’s son turned his father in,” note the researchers. “Thus, in the eyes of some, the Madoff fraud was seen as a failure of the SEC.”

As a result, many people socially connected to Madoff’s victims lost their trust in the financial system. To understand how this loss of trust may have affected their investment behavior, Stoffman and his colleagues analyzed social networks.

Specifically, the researchers used court documents to get a complete list of Madoff’s victims and then created a map of affected areas. Next, accessing data from the Federal Deposit Insurance Corp., the team performed an analysis of assets to see who invested in risky financial products versus who deposited their cash in banks. “There’s not the same concern someone might be ripping you off when you place your money in a federally-insured bank account,” said Stoffman.

In areas of the country where many of Madoff’s victims resided — including the Northeast, South Florida, and Southern California — higher levels of bank deposit activity occurred, the researchers discovered. At the same, these same communities showed a sharp decline in assets placed with registered investment advisors. In response to decreased assets under management, these same advisory firms were more likely to close.

Ultimately, the researchers estimate this “trust shock” amounted to $430 billion in liquidated assets, which is 25 times the estimated size of direct wealth lost.

Like a virus, then, mistrust spread through communities, affecting many people who were not directly touched by the Ponzi scheme. Ultimately, then, Madoff hurt the American economy as a whole and is now serving a 150-year prison sentence.

Source: Gurun UG, Stoffman N, Yonker SE. Trust Busting: The Effect of Fraud on Investor Behavior. National Bureau of Economic Research’s Behavioral Finance working group. 2016.