Tuesday, December 16, 2008

Bernie Made-off And The Blame Game

Bernie Madoff "lost" $50 billion. $50 billion. $50 billion. With all of the federal bailouts that have been flying, it took me a minute to remember that $50 billion is still a huge sum. You have to wonder if Bernie was hoping that a mere $50 billion would get lost in the noise of the serial federal bailouts and the impending auto industry Christmas present.

To briefly recap, Madoff was (until a few days ago) a very respected Wall Street investor who, among other things, was investing billions of dollars for institutions and the (once) well-to-do. Unable to meet requests for redemptions, Bernie was finally forced to admit that his asset management operation was a fraud and that the losses totaled something in the $50 billion neighborhood. It appears to be your classic Ponzi scheme, in which Bernie used new money to cover distribution requests.

There are plenty of questions. How could he have done this alone? How did the SEC miss this? Where did the money go? How charming is this guy? Should we bring back stoning? The most interesting question to me is what happened with the due diligence efforts of the regulators, professional investors, and institutions that invested with Bernie. Pass the buck time has arrived.

There are a few hedge funds that recognized that Bernie's operation didn't pass the smell test, and they're deservedly getting some good press recently. They'll probably be getting more assets to manage as well. As for the regulators and professional investors who were duped, they don't look so good.

From the New York Times:

Jeffrey Tucker, a Fairfield co-founder and former federal regulator, said in a statement posted on the firm’s Web site: “We have worked with Madoff for nearly 20 years, investing alongside our clients. We had no indication that we and many other firms and private investors were the victims of such a highly sophisticated, massive fraudulent scheme.”

Fairfield boasted about its investigative skills. On its Web site, the firm claimed to investigate hedge fund managers for 6 to 12 months before investing. As part of the process, a team of examiners conducted personal background checks, audited brokerage records and trading reports and interviewed hedge fund executives and compliance officials.
From BBC News:

Nicola Horlick, boss of Bramdean investments, said US regulators had "fallen down on the job".

Mrs Horlick told the BBC: "I think now it is very difficult for people to invest in things that are meant to be regulated in America, because they haven fallen down in the job."

In a statement, Bramdean said: "It is astonishing that this apparent fraud seems to have been continuing for so long, possibly for decades, while investors have continued to invest more money into the Madoff funds in good faith.
It's easy to Monday-morning quarterback, but it seems that there were plenty of red flags that any reasonable level of due diligence would have discovered. Take Madoff's accounting firm, for instance. From Bloomberg:

Friehling & Horowitz included one partner in his late 70s who lives in Florida, a secretary, and one active accountant, Aksia said.

...The firm operates from a storefront office in the Georgetown Office Plaza in New City, New York, sandwiched between a pediatrician’s office and another medical office.

Leslie Cousar, who works in a nearby office, said on Dec. 12 that the man who comes to the auditor’s office does so for 10-to- 15 minute periods and leaves. She said he drives a Lexus and doesn’t dress in business attire.

What about Madoff's investment performance? I haven't seen the numbers, but from what I've read he apparently claimed to consistently earn 1.0-1.5% every month, year in and year out regardless of market returns and with only a few down months. I couldn't even type that with a straight face. A few down months with a strategy that generates low double digit annual returns? In the short-term, sure. Bernie, however, apparently claimed to be doing this for a long time. At some point, this simply becomes statistically impossible.

The institutions and fund-of-funds investing with Madoff had to do some level of due diligence before handing over their money. Perhaps they were willing to overlook Madoff's vague description of his investment style and his use of some hole-in-the-wall company as his accounting firm, but if they were presented with the type of long-term returns presented above, they should have teared up from laughing too hard.

Some professionals did see the improbability of Madoff's results. Those who didn't, can and will try to cover their backsides by arguing that they were duped by an incredibly sophisticated con man and that there was nothing else they could have done. Regardless, they will justifiably be sued by their investors. Those, like Fairfield, that made a point of stressing their investigative skills seem particularly vulnerable (if they have any money left).

As for the regulators, they clearly and spectacularly failed -- again. Unfortunately, this will lead to calls for broader and deeper regulation. Regulation fails? Then we must need more! I imagine a number of Madoff investors took some comfort in knowing that the SEC had investigated Madoff and signed off. Perhaps if the SEC didn't exist, investors would have spent a little more effort themselves looking into his operation. Alas, the SEC is likely to benefit from its amazing failure by being given even greater funding. Perhaps the defrauded investors will sue the SEC for negligence.

Disclosure: The Rubbernecker is long the "smell test," and short the SEC and statistical impossibilities.

The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.