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For years there were whispers on Wall Street about Bernard Madoff’s hedge fund. The cynics said the returns were too good, too steady and Madoff’s operation always looked too slim for the tens of billions of dollars it was managing. But given Madoff’s more than four-decades of experience as trader and past service as chairman of the Nasdaq Stock Market the wealthy kept giving him their money.

Well, it looks like those concerns were right all along now that federal prosecutors have charged the 70-year-old Madoff with securities fraud, in what could amount to one of the biggest Wall Street scams ever. Securities regulators, in a civil complaint, say Madoff’s scheme may have cost investors up to $50 billion—although that figure appears to be based on Madoff’s own bravado. At a minimum, it appears the $17 billion Madoff was managing earlier this year may be gone.

The allegations against Madoff describe a classic Ponzi scheme, in which money is taken in from new investors to pay out money to earlier investors. Madoff, authorities allege, even told his sons earlier this week that the hedge fund was nothing more than “a giant Ponzi scheme.’’

It didn’t take long for investors in Madoff’s fund to begin crying foul. Hours after the news of Madoff’s arrest broke, investors were contacting lawyers to determine how they can get their money back—assuming there is any money left over. The Securities and Exchange Commission is moving to appoint a receiver to take control of the Madoff fund to protect whatever assets remain. Scott Berman, a lawyer who represents a number of Madoff investors, says the fear in a case like this is that the investors will be left “fighting over the crumbs.”

It’s way to soon to know how long the alleged scheme had been going on, although authorities allege it began years ago, after Madoff tried to cover up for past losses. But it appears Madoff ultimately was unmasked by the worst financial crisis since the Great Depression. Just like many hedge fund operators, Madoff received a wave of redemption notices in recent months, from investors looking to preserve cash. Authorities say investors sought to pull-out some $7 billion from the fund—money Madoff apparently did not have.

In the end, most Ponzi schemes collapse when too many investors seek to pull their money out at the same time, and the operator doesn’t have the cash on hand. Many a scheme has failed when the markets turn south. One potential red flag that investors failed to notice along the way is that the hedge fund was being audited by a small outfit in Rockland County, NY—not one of the large accounting firms.

But the financial crisis appears to be hastening the unwinding process of potential scams, as it has dried-up all sources of liquidity. Banks are unwilling to lend and investors are fleeing hedge funds, stocks, bonds, commodities and other asset classes for the safety of cash.

In September, another alleged Ponzi scheme collapsed, when federal prosecutors arrested Minnesota businessman Tom Petters. Federal prosecutors allege that much of Petters’ empire, which consisted of buying up distressed businesses, was based on a series of lies. He’s been charged with bilking some six-dozen hedge funds out of $3 billion. Petters’ alleged scheme came undone when some of the hedge funds that lent him money had gotten redemption requests from their investors and began asking Petters to pay-off his debt. Just like Madoff, Petters apparently couldn’t come up with the cash. Several of the hedge funds that lent money to Petters are in tatters, and some are shutting down.

A lack of liquidity may have been behind the bizarre scheme involving New York attorney Marc Dreier. Earlier this week, federal prosecutors charged the high-profile attorney with allegedly scamming several hedge funds into giving him up to $100 million by selling shares in what appears to be a fraudulent real estate venture. It appears Dreier’s 250-lawyer firm was running low on cash and had failed to make payments on a bank loan.

As the financial crisis deepens, don’t be surprised if other scams get flushed out in the coming weeks and months.

Michael Austin

Over risotto at Ca' Brea, former Sony (SNE) Pictures Chairman Peter Guber is lamenting the state of his industry. A movie he's trying to get made is in limbo, held up by a bank that wants him to put up more money before making a deal. "No one wants to lend money these days for an asset that will take months to create," Guber says, before rushing off to plead with his banker.
Over risotto at Ca' Brea, former Sony (SNE) Pictures Chairman Peter Guber is lamenting the state of his industry. A movie he's trying to get made is in limbo, held up by a bank that wants him to put up more money before making a deal. "No one wants to lend money these days for an asset that will take months to create," Guber says, before rushing off to plead with his banker.

Like the rest of Hollywood, Guber is discovering that Los Angeles' Dream Factory is not immune when the rest of the country slips into recession. Cinemas around the U.S. are selling fewer tickets. DVD sales, a major profit engine, are tanking. And within weeks, the Screen Actors Guild may authorize a strike that could throw Hollywood into its second work stoppage in a year.

It's hard to spot the worry lines when half the town is botoxed. But the angst is there. Yes, television production is booming. But a lot of that activity is the networks and studios playing catch-up after losing 14 weeks to the writers' strike that shut down Hollywood earlier this year. And while some wonder whether SAG would actually strike at a moment of such economic vulnerability, the studios are quietly pulling back. They are slower to green-light pricey films, and the networks are ordering shows without expensive pilots.

Even before the economy went off the rails, studios were making fewer movies. Box office tracker Media by Numbers says they will release about 450 films this year, 67 fewer than in 2007. Next year there will be even fewer. Paramount (VIA) has said it will make 20 films each year, not 25. Time Warner (TWX) shut its New Line Cinema unit. Meanwhile, even leviathans are having trouble funding movies. Steven Spielberg's DreamWorks SKG has been talking to banks for weeks about how to structure a $750 million line of credit.

COMPETING LOCATIONS
To make matters worse for the Los Angeles economy, cash-strapped states are using hefty tax incentives to lure away films and TV shows. In late November, Illinois passed a 30% tax credit to woo productions (Michigan already has a 40% credit), and earlier this year New York upped its credit to 35%. Los Angeles has since lost two TV shows to New York: HBO's (TWX) In Treatment and ABC's (DIS) Ugly Betty. "L.A. needs to do more, or this will keep happening," says Ugly Betty creator Silvio Horta. "Sooner or later, Hollywood will just be a state of mind, not an actual location for productions."

Back in California, an alarmed Governor Arnold Schwarzenegger is urging the state legislature to pass its own sweeteners. His plea comes as some studios are starting to lay off people. NBC Universal is whacking its budget by $500 million, and staff there are bracing for pink slips. Lions Gate Entertainment (LGF), which produces AMC's (AC) Mad Men, laid off 41. And just before Thanksgiving, The Weinstein Co. let go 24 people, or 11% of its staff.

The economic situation in Hollywood is hardly as dire as it is in, say, the Midwest. But then, Tinseltown has long prided itself as being recession-proof. "This is nuts," says an actor-turned-waiter named Justin. "It's like we're in the auto industry."