Mr. Madoff and his Ponzi fund

[bigbadwolf]

This looks like a fun read:

Bernie's mega-fund shared many signs with recent high level scams: The constant high returns, unmatched by any other broker; a lack of third party oversight; a backroom accounting firm physically incapable of auditing the multi-billion dollar operation; a broker-dealer operation directly under his thumb and the total obfuscation of what he was actually investing in.

 

[Subramaniam]

One thing that I fail to understand with this scam after all the previous things like subprime is: do the buyers never do any due diligence? Do they just rely on word of mouth/ rating agencies before they decide to invest(throw) their money to perhaps wolves?

The current debate has so far focussed on regulators, government oversight, rating agencies etc.. So far the debate has never included buyers and investors. I think it is high time we debate their role in the entire crisis.

If there were no buyers for all this nonsense, such crisis can be avoided even if the regulators, oversight agencies, sellers etc are a fraud.

 

[Ross]

I don't get it. How were there $50 billion in losses? A ponzi scheme just involves taking money from person A and giving it to person B. So how was real money lost? It sounds like these investors just lost the fictitious, extraordinarily high returns they thought they'd been making.

 

[Eugene Krel]

I may be wrong, but doesn't person A lose the money that goes to person B in a ponzi scheme?

 

[Andy Nguyen]

There are always suckers unsophisticated investors in any market. Retirees who put every dollar they have into Mr. Madoff's fund may not have all the tool that other investors have but after all, they are all after his consistent return record.

What do we as investors really know about how money is made at a certain place anyway? For all we know, maybe Mr. Buffet is operating a Ponzi scheme as well.

When the SEC ignores early warnings from investors about Mr. Madoff, there isn't much Joe the plumber can do.

 

[Ross]

I may be wrong, but doesn't person A lose the money that goes to person B in a ponzi scheme?

There was an article in the journal the other day regarding the ability of a court appointed receiver to pull back the money from person B under the doctrine of fraudulent conveyance. My point is that as a whole the investors didn't lose $50 billion.

 

[Andy Nguyen]

I don't get it. How were there $50 billion in losses?

I assume the $50B figure is the total principal loss from all investors. Money inflow got paid out to earlier investors, salary for the firm's employees, living expense for Mr. Madoff, so on. Since this has gone on for so long, there isn't much money left.

Wikipedia has an article that mentions the legal doctrine that may help investors to get back some money but it has a long way to go.
Bernard Madoff - Wikipedia, the free encyclopedia

 

[Ross]

I assume the $50B figure is the total principal loss from all investors. Money inflow got paid out to earlier investors, salary for the firm's employees, living expense for Mr. Madoff, so on. Since this has gone on for so long, there isn't much money left.

Wikipedia has an article that mentions the legal doctrine that may help investors to get back some money but it has a long way to go.
Bernard Madoff - Wikipedia, the free encyclopedia

If this was just a Ponzi scheme:

Total principal loss = losses for some investors - gains to others = 0

There's no way he spent it. Maybe he just didn't have any of the supposed collars on his positions and the bottom fell out of his portfolio this year just like everybody else's.

 

[bigbadwolf]

If this was just a Ponzi scheme:

Total principal loss = losses for some investors - gains to others = 0

There's no way he spent it. Maybe he just didn't have any of the supposed collars on his positions and the bottom fell out of his portfolio this year just like everybody else's.

I don't know where the $50bn figure came from. He was only managing $17bn. Unless he made some disastrous trades with no collars, as you say.

Generally investors don't pull their money out of such a scheme but let it "compound." If the operator of such a fund is not doing anything with the money, then there are substantial real losses overall over a period of time. For example, if I put $100 into the fund twenty years ago, and collect $100 today, I have obviously made a real loss. Furthermore, in this case, I presume creditors (legally) have first crack at whatever is in the fund, and the investors get whatever is remaining. But I don't know. Is the investigation of this Ponzi scheme just as murky as the operation of it was?

Certainly there is a niche for a text: "How to start, operate, and bailout of a Ponzi fund."

I think one point to be made is that Mr. Madoff's remarkable fund is just the tip of an iceberg in some ways. And this iceberg exists because accounting and law are not transparent, and not meant to be. In the naivete of my youth, I used to believe that reading balance sheets, income statements, and cash flow statements was straightforward and they were a transparent window through which to gauge the health and profitability of an operation. I long since abandoned this point of view. Just look at Enron accounting -- and Enron was another tip of the same iceberg. Or look at what banks have been doing with "off-balance-sheet items" and "structured investment vehicles." The problem is that even professional analysts cannot understand what is really happening from financial statement analysis. Fraud is the inevitable consequence of this.

Postscript: An amusing article by Paul Krugman at Herald Tribune:

... Yet surely I'm not the only person to ask the question: How different, really, is Madoff's tale from the story of the investment industry as a whole?

 

[doug reich]

If this was just a Ponzi scheme:

Total principal loss = losses for some investors - gains to others = 0

There's no way he spent it. Maybe he just didn't have any of the supposed collars on his positions and the bottom fell out of his portfolio this year just like everybody else's.

My understanding is that $17 billion was principle invested, and $50 billion was total "net worth", i.e. principle plus "trading profits" that mostly never existed.

Clearly Madoff was taking something out, because he has a number of homes and yachts. Therefore money in - money out > 0. You are right that he often did not hold the positions he claims he did, picking them ex-post to suit his desired returns. That "accounts" for the "33 billion" lost. To lose the remaining huge number, I would guess it's a combination of embezzlement and extremely poor trading.

 

[Andy Nguyen]

Some heads at SEC will have to roll.

Signs of trouble

Outside analysts raised concerns with Madoff's firm for years.[10] Financial analyst Harry Markopolos complained to the SEC's Boston office in May 1999 telling the SEC staff they should investigate Madoff because it was impossible for the kind of profit Madoff claimed to have been made legally.[51] Among the suspicious signs were the fact that Madoff's company avoided filing disclosures of its holdings with the SEC by selling its holdings for cash at the end of each period.[10] Such a tactic is highly unusual. Madoff's use of a small auditing firm, Friehling & Horowitz, which has only one active accountant, is also highly unusual.[52] Friehling & Horowitz has reported since 1993, in writing, to the American Institute of Certified Public Accountants that it doesn't conduct audits.[53]

While hedge funds typically hold their portfolio at a securities firm that acts as the fund's prime broker (typically a major bank or brokerage), allowing an outside investigator to verify their holdings, Madoff's firm was its own broker-dealer and supposedly processed all its trades.[41]
Although Madoff was a pioneer of electronic trading, he refused to provide his clients online access to their accounts.[10] He sent out accounting statements by mail, whereas most hedge funds email statements and allowed them to be downloaded via computer for easier analysis by investors.[22]
Improbably steady investment returns despite exceedingly volatile markets was another red flag.[54] A longtime friend said that "his rate of return [...] was never attention-grabbing, just solid 12–13 percent year in, year out".[11] Robert Ivanhoe, chairman of the real estate practice of the law firm Greenberg Traurig, added that Madoff increased his allure by refusing some investors.[11]

The SEC said it conducted two inquiries of Madoff in the last several years and did not find major problems.[55] An SEC statement detailed that inspectors examined Madoff's brokerage operation in 2005, finding three violations of rules requiring brokers to obtain the best possible price for customer orders, while in 2007, SEC enforcement staff completed an investigation and did not refer the matter to the SEC commissioners for legal action.[56]

Charles Gradante, co-founder of hedge-fund research firm Hennessee Group, observed that Madoff "only had five down months since 1996",[57] and commented on Madoff's investment performance: "You can't go 10 or 15 years with only three or four down months. It's just impossible."[54]
Madoff also operated as a broker dealer with an asset management division. Joe Aaron, a longtime hedge fund professional, found the structure suspicious and in 2003 warned a colleague to steer clear of the fund, saying "Why would a good businessman work his magic for pennies on the dollar?"[58]

Early indications that Madoff may have been in trouble emerged in 2007. The Madoff Family Foundation donated only $95,000 to charitable groups. This was a major drop from previous years. In 2006, the foundation donated $1,277,600.[37]

The scheme began to unravel when, in 2008, clients wanted to withdraw $7 billion from the firm and Madoff was struggling to raise $7 billion to cover redemptions. On December 10, 2008, he suggested to his sons that the firm pay out several million dollars in bonuses two months ahead of schedule. Then at his apartment, he admitted to his sons that his firm was a fraud.[55]

 

[bigbadwolf]

Some heads at SEC will have to roll.

The wrong ones. And just for show. And don't forget the lengthy investigation that will peter out inconclusively months or even years from now. Seen it all before.

 

[Ross]

My understanding is that $17 billion was principle invested, and $50 billion was total "net worth", i.e. principle plus "trading profits" that mostly never existed.

Clearly Madoff was taking something out, because he has a number of homes and yachts. Therefore money in - money out > 0. You are right that he often did not hold the positions he claims he did, picking them ex-post to suit his desired returns. That "accounts" for the "33 billion" lost. To lose the remaining huge number, I would guess it's a combination of embezzlement and extremely poor trading.

From my limited Internet research, Madoff's homes and yachts consisted of the following:

1. A Manhattan apartment bought for $3.325 million
2. A Palm Beach home valued at $23 million
3. A home in Montauk valued at $3.3 million
4. A yacht bought for $462,000

Altogether this comes to $30.1 million or 0.06% of $50 billion. In other words, whatever amount he spent must have been completely immaterial compared to the amount "lost." The only explanations I can think of are that either (a) his real portfolio performed disastrously badly or (b) the money that everyone is saying was "lost" never existed in the first place.

 

[doug reich]

I suppose like any Ponzi scheme it basically worked like this:

* He raises $100 in 1990 and pockets it.
* He raises $200 in 1992, and returns that money to the investors from 1990, who have made a nice return.
* He raises $400 in 1994, and returns that money to those from 1992.
* etc.
* He raises $17b in 2006, and returns that money to those from 2004.
* He can't raise any money in 2008 because investors are scared. He has promised $50 billion to those in his fund: he can't meet redemptions because he has no real assets.

Suppose he kept half the money in the fund to maintain the appearance of actually having a business, and you're pretty much there, give or take some timing and using actual numbers.

Anyway, he may also have a huge $1b slush fund in Switzerland to escape to. I agree, it is hard to make all that money go away, huh?

 

[bigbadwolf]

There's some video footage of Nouriel Roubini at the FT site wondering, in passing, how many other Ponzi funds there are out there. There are still a number of financial skeletons in the closet, as he contends.

 

[doug reich]

It seems a lot of money went to other institutions. If there were no meaningful earnings from investment, then this is all investor capital.

http://www.nytimes.com/2008/12/22/business/22fairfield.html?hp

 

[bigbadwolf]

SEC oversight of Mr. Madoff's remarkable fund here:

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I seldom have the urge to give a comforting pat on the back to people profiled in the Wall Street Journal. But that was my reaction when I read the 21-page whistleblower document about Madoff that was written by Harry Markopolos to the Securities and Exchange Commission (SEC) on November 7, 2005. The Journal still has the document on its web site and Markopolos provides a step by step plan for the SEC to follow to nail Madoff as a Ponzi fraudster. The letter followed a five-year effort by Markopolos, who supplied documentation and made repeated requests to the SEC to investigate Madoff.
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[FONT=Verdana, Arial, Helvetica, sans-serif][SIZE=-1]Here's how the SEC characterized the letter from Markopolos in a January 4, 2006 memo: "The staff received a complaint alleging that Bernard L. Madoff Investment Securities LLC, a registered broker-dealer in New York ("BLM"), operates an undisclosed multi-billion dollar investment advisory business, and that BLM operates this business as a Ponzi scheme. The complaint did not contain specific facts about the alleged Ponzi scheme..."[/SIZE][/FONT]
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[FONT=Verdana, Arial, Helvetica, sans-serif][SIZE=-1]Here's a tiny sampling of what Markopolos told the SEC in his 21-page November 7, 2005 letter. You decide if these are "specific facts."

"I am a derivatives expert and have traded or assisted in the trading of several billion $US in options strategies for hedge funds and institutional clients...(Highly Likely) Madoff Securities is the world's largest Ponzi Scheme...The [Madoff] family runs what is effectively the world's largest hedge fund with estimated assets under management of at least $20 billion to perhaps $50 billion...The third parties organize the hedge funds and obtain investors but 100% of the money raised is actually managed by Madoff Investment Securities, LLC in a purported hedge fund strategy. The investors that pony up the money don't know that BM [Bernie Madoff] is managing their money...Some prominent US based hedge fund, fund of funds, that "invest" in BM in this manner include: A. Fairfield Sentry Limited (Arden Asset Management) which had $5.2 billion invested in BM as of May 2005...Access International Advisors...which had $450 million invested with BM as of mid-2002...Tremont Capital Management, Inc...Tremont oversees on an advisory and fully discretionary basis over $10.5 billion in assets. Clients include institutional investors, public and private pension plans, ERISA plans, university endowments, foundations, and financial institutions, as well as high net worth individuals...Madoff does not allow outside performance audits. One London based hedge fund, fund of funds, representing Arab money, asked to send in a team of Big 4 accountants to conduct a performance audit during their planned due diligence. They were told 'No, only Madoff's brother-in-law who owns his own accounting firm is allowed to audit performance'...Only Madoff family members are privy to the investment strategy. Name one other prominent multi-billion dollar hedge fund that doesn't have outside, non-family professionals involved in the investment process. You can't because there aren't any...There are too many red flags to ignore. REFCO, Wood River, the Manhattan Fun, Princeton Economics, and other hedge fund blow ups all had a lot fewer red flags than Madoff and look what happened at those places..."[/SIZE][/FONT]
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[FONT=Verdana, Arial, Helvetica, sans-serif][SIZE=-1]Here is what the SEC's memo of November 21, 2007 said following its investigation:[/SIZE][/FONT]

[FONT=Verdana, Arial, Helvetica, sans-serif][SIZE=-1]"The staff found no evidence of fraud...All files have been prepared for closing...Termination letters have been sent to Bernard L. Madoff Investment Securities LLC, Bernard L. Madoff, and Fairfield Greenwich Group. The staff has no objection to the eventual destruction of the files and has no knowledge of any impediment to such a disposition."[/SIZE][/FONT]
​

[FONT=Verdana, Arial, Helvetica, sans-serif][SIZE=-1]Let me run that by you again. Mr. Markopolos, a private citizen, uses his personal time and energy over a seven year period to document a fraud occurring under the nose of the SEC that could impact the international reputation of the United States along with the financial well being of pensioners, university endowments, foundations and private investors. After losing track of the case for five years, the SEC finally gets around to investigating using taxpayers' monies. They come up with nothing despite being given a perfect path to follow to the fraud. And their final suggestion for dealing with the investigation is to destroy the files! With regulators like these, who needs Ponzi artists?

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[Ross]

It seems a lot of money went to other institutions. If there were no meaningful earnings from investment, then this is all investor capital.

http://www.nytimes.com/2008/12/22/business/22fairfield.html?hp

Assume Fairfield used the standard 2 and 20 management fee and carry. Since Madoff was claiming to have 12% annual returns, that means Fairfield charged 4.4% a year. If the real earnings on Madoff's portfolio were zero, then it would still take 25 years for all the principal to get sucked up by Fairfield.

 

[doug reich]

Fairfield and many others, plus his Ponzi scheme that I described below.

Here is some additional reading on Madoff, seems to be an increasingly popular take on the situation.

Here's a funny coincidence:

According to the criminal complaint, Mr. Madoff (pronounced MADE-off) told his sons there was approximately $200 million to $300 million left in his business as of last week and that he wanted to distribute to employees before turning himself in to authorities.

That's right, Madoff made off with the dough.

 

[bigbadwolf]

That's right, Madoff made off with the dough.

Bless his kind heart, he did try to distribute the remaining $200m-$300m to the employees -- so he can't be all bad. Nor does he look like a bad sort of fellow from his pictures -- he looks like an avuncular sort. I hope the authorities don't treat him too severely -- after all, it's only money.