Psychological toll of Madoff fraud case went far beyond the victims, study finds

Among them will be Noah Stoffman, an associate professor of finance in Indiana University's Kelley School of Business, who suspects that some of Madoff's victims will be watching as well.

Like other successful Ponzi schemes, Madoff's took advantage of what researchers call an "affinity relationship." Madoff is Jewish, and nearly everyone who was "invited" to invest with his firm was Jewish. Many were active within the Jewish philanthropic community.

In a new paper, Stoffman and two co-authors set out to study where Madoff's fraud case left its deepest impact and on whom -- not just among his direct victims, but also on how others viewed the trustworthiness of financial markets.

"The cost of a fraud like this is much larger than just the money that was lost by the victims," Stoffman said. "We showed that about $430 billion was moved out of risky assets and into bank accounts as a result of this fraud. That has a huge potential economic impact."

In other words, because of what happened to Madoff's victims, their neighbors, friends and others in the same "affinity group" may have left perfectly good investments, costing themselves higher financial returns, at a time when returns potentially were very high.

Stoffman and associates, Umit Gurun of the University of Texas at Dallas and Scott Yonker of Cornell University, used court documents to get a complete list of Madoff's victims and then created a map of affected areas. That was then used to perform a statistical comparison of outcomes, in terms of who invested in riskier assets versus cash deposits in banks.

In areas of the country where many of Madoff's victims resided -- such as the Northeast, South Florida and Southern California -- they found a precipitous decline in the use of registered investment advisors, people who provide service to access financial markets.

At the same time, using data from the Federal Deposit Insurance Corp., Stoffman and his colleagues found higher levels of bank deposit activity in those same areas.

"We saw this shift in areas that were more affected by the Madoff shock," said Stoffman, who studies the role of social interactions in investment decisions. "We saw a shift from risky investments to safe investments. Among those people who somehow are more exposed to the fraud, it affects their investment behavior.

"We can't track person by person to see what they did with their money, but we have a sense in the aggregate that this money was shifted from risky assets to cash and probably ended up earning lower returns than it would have."

The paper, "Trust Busting: The Effect of Fraud on Investor Behavior," will be presented in March at the Conference on Financial Decisions and Asset Markets, hosted by the Wharton School's Rodney L. White Center for Financial Research. It also was presented recently at a meeting of the National Bureau of Economic Research's Behavioral Finance working group.

They did find that the same people had more trust in investment advisors, who provide additional services -- such as financial planning and tax services -- face to face, and thus build a deeper relationship with clients.

In the past two decades, the Securities and Exchange Commission has investigated more than 360 Ponzi schemes, but the Madoff scheme dwarfed them all and provided the researchers with a good "testing ground" to study trust.

The Madoff case directly affected many geographically dispersed investors whose trust was shaken -- as shown in the 113 victim impact statements, which mention "trust" 45 times. Because the fraud targeted a particular group of investors, Stoffman and his colleagues were able to study how trust shock was transmitted through social networks.

Stoffman suspects that the miniseries starring Richard Dreyfuss and Blythe Danner may lead some to revisit the emotions they had in 2008, when Madoff's actions came to light.

"It's entirely possible that people who either had previously been affected, whose trust was diminished in the past, may be reminded now of this event, and it may well have another effect in that more people may want to shift their assets to something that's less risky now," he said.