Bernard Madoff was the head of a multi-billion dollar hedge fund on Wall Street. Today, he was arrested for allegedly running a Ponzi Scheme.

For financial beginners, I’m going to break this down to the very basics because this arrest is one of the biggest financial frauds in American history, and the ramifications are potentially enormous. People need to be informed.

First some definitions:

A Ponzi scheme is loosely defined as a fraudulent investment scheme that involves promising high returns to early investors out of the money paid in by later investors. Basically, in a Ponzi scheme, the business only makes money by suckering more and more investors into pouring money into the fund. This is illegal because investors think they are investing in an underlying business that will generate profits and revenue and lead to long-term returns to the investors. The head of the scheme knows this will never happen.

A Hedge Fund is a private investment fund open to a limited range of investors that is allowed to engage in a wider range of risky activities than most investment funds (i.e. your 401k, which is heavily regulated). Hedge funds are able to use methods not available to other investments, like short selling (borrowing shares to sell immediately on the open market), derivative contracts, and leverage (borrowing money to buy securities). Using these different methods allows the fund to “hedge” the risk, like a gambler “hedges” his bets by making a variety of bets.

Complicated? Yes, it is. As a matter of fact, very few people outside of Wall Street understand what hedge funds do and how they make money. There are very few regulations governing hedge funds because they are so complex. Also, generally, the Securities and Exchange Commission only lets really rich people invest in hedge funds.

THE BERNARD MADOFF ALLEGATIONS

Bernard Madoff
, 70, is the founder of Bernard L. Madoff Investment Securities LLC, which has grown into a multi-billion institution since its founding in 1960. Public information on Madoff’s company is available here at its website.

Madoff’s company included a brokerage house and a hedge fund. According to state prosecutors, Madoff told his staff this week that the hedge fund was “basically, a giant Ponzi scheme.” Investors have put in $50 billion into the hedge fund.

In court today, state prosecutors charged Madoff with securities fraud. The maximum sentence is 20 years in prison and a fine of up to $5 million. Madoff is currently out on $10 million bail. The Securities and Exchange Commission is filing separate charges.

Why is this such a big deal?

According to the Wall Street Journal, approximately $2 trillion are currently invested in hedge funds. The hedge fund world is the financial Wild West, with little regulation and very few people with an actual clue as to where the money is really going. Given today’s crisis in the financial markets, allegations of fraud may shake investors confidence in the hedge fund world.

Hopefully, Madoff’s case turns out to be an isolated incident and the hedge fund world will survive.