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Sunday, October 30, 2011

Reading List: No One Would Listen

Markopolos, Harry. No One Would Listen. Hoboken, NJ: John Wiley & Sons, 2010. ISBN 978-0-470-91900-2.
Bernard L. “Bernie” Madoff was a co-founder of NASDAQ, founder and CEO of a Wall Street firm which became one of the top market makers, and operator of a discretionary money management operation which dwarfed hedge funds and provided its investors a reliable return in markets up and down which no other investment vehicle could approach. Madoff was an elder statesman of Wall Street, respected not only for his success in business but also for philanthropic activities.

On December 10th, 2008, Madoff confessed to his two sons that his entire money management operation had been, since inception, a Ponzi scheme, and the next day he was arrested by the FBI for securities fraud. After having pleaded guilty to 11 federal felony charges, he was sentenced to 150 years in federal incarceration, which sentence he will be serving for the foreseeable future. The total amount of money under management in Madoff's bogus investment scheme is estimated as US$65 billion, although estimates of actual losses to investors are all over the map due to Madoff's keeping transactions off the books and offshore investors' disinclination to make claims for funds invested with Madoff which they failed to disclose to their domicile tax authorities.

While this story broke like a bombshell on Wall Street, it was anything but a surprise to the author who had figured out back in the year 2000, “in less than five minutes”, that Madoff was a fraud. The author is a “quant”—a finance nerd who lives and breathes numbers, and when tasked by his employer to analyse Madoff, a competitor for their investors' funds, and devise a financial product which could compete with Madoff's offering, he almost immediately realised that Madoff's results were too good to be true. First of all, Madoff claimed to be using a strategy of buying stocks with a “collar” of call and put options, with stocks picked from the S&P 100 stock index. Yet it was easy to demonstrate, based upon historical data from the period of Madoff's reported results, that any such strategy could not possibly avoid down periods much more serious than Madoff reported. Further, such a strategy, given the amount of money Madoff had under management, would have required him to have placed put and call option hedges on the underlying stocks which greatly exceeded the total open interest in such options. Finally, Madoff's whole operation made no sense from the standpoint of a legitimate investment business: he was effectively paying 16% for capital in order to realise a 1% return on transaction fees while he could, by operating the same strategy as a hedge fund, pocket a 4% management fee and a 20% participation in the profits.

Having figured this out, the author assumed that simply submitting the facts in the case to the regulator in charge, the Securities and Exchange Commission (SEC), would quickly bring the matter to justice. Well, not exactly. He made his first submission to the SEC in May of 2000, and the long saga of regulatory incompetence began. A year later, articles profiling Madoff and skating near the edge of accusing him of fraud were published in a hedge fund trade magazine and Barron's, read by everybody in the financial community, and still nothing happened. Off-the-record conversations with major players on Wall Street indicated that many of them had concluded that Madoff was a fraud, and indeed none of the large firms placed money with him, but ratting him out to The Man was considered infra dig. And so the sheep were sheared to the tune of sixty-five billion dollars, with many investors who had entrusted their entire fortune to Madoff or placed it with “feeder funds”, unaware that they were simply funnelling money to Madoff and skimming a “management and performance fee” off the top without doing any due diligence whatsoever, losing everything.

When grand scale financial cataclysms like this erupt, the inevitable call is for “more regulation”, as if “regulation” ever makes anything more regular. This example gives the lie to this perennial nostrum—all of the operations of Madoff, since the inception of his Ponzi scheme 1992 until its undoing in 2008, were subject to regulation by the SEC, and the author argues persuasively that a snap audit at any time during this period, led by a competent fraud investigator who demanded trade confirmation tickets and compared them with exchange transaction records would have uncovered the fraud in less than an hour. And yet this never happened, demonstrating that the SEC is toothless, clueless, and a poster child for regulatory capture, where a regulator becomes a client of the industry it is charged to regulate and spends its time harassing small operators on the margin while turning a blind eye to gross violations of politically connected players.

An archive of original source documents is available on the book's Web site.

Posted at October 30, 2011 23:34