This Is the End


Markets, Risk and Human Interaction

January 2, 2009

Reflections on Madoff

The Madoff Ponzi scheme will (I hope) be the high watermark for financial fraud for many decades to come. It is hard to overstate the harm it has done, with lifesavings and fortunes lost, charities and schools left foundering.

“It fell off a Truck”
Did his investors really believe Madoff was doing split-strike conversions? Given that there were not enough options in the world for Madoff to do such a strategy? And given that no one in the industry heard of him as a player in that market?

An alternative view is that the split-strike conversion story is the equivalent of the “it fell off the truck” story for people buying stolen goods; that investors suspected he was involved in illegal front running, and would just as soon not have had that spelled out for them while the money kept flowing in.

It’s the same old story, just bigger – and smaller
Bigger because people have more money. Bigger because it is easier to create links and indirect “circles of trust” by using banks and other feeder funds as agents. Bigger because it was bigger: people implicitly trusted the regulators to do their job, and thought that surely nothing could be fraudulent if it was this large and well known.

But part of his genius was that in one respect his scheme also was smaller. He did not make the classic confidence artist’s play on avarice. The good, old fashioned Ponzi schemes are of the get-rich-quick, double your money in three months variety. Madoff’s was conservative, offering lower expected returns than many other investment opportunities.

Putting all your eggs in one basket

Madoff could get away with modest but steady returns because with credit so abundant his investors could use leverage to push the returns up. My guess is that in many cases the people who were wiped out did not have their entire portfolio in just this one fund, but rather borrowed money to create a levered position. If you can make 10% almost for certain, why not lever four times and get 40% return with a little more volatility? Because of that leverage, the fund’s failure engulfed their other investments.

We are shocked, shocked
The day after the story broke, I wondered why Madoff didn’t just grab $30 million and skip town. The likely answer is that then his kids would have been left holding the bag. I would have loved to hear the conversations between him and his sons the night they heard the gig was up, and decided they would have to turn him in.

How could anyone so close to the scheme, and in the market making business to boot, not see any of the red flags that Harry Markopolos was waving in front of the SEC for the past ten years? I wonder if they had all of their money in their Dad’s fund?

Is there a managed account in your future?
A lot of investors are going to be asking, “So remind me again what the problem is with putting me in a managed account?’ Why can’t a hedge fund operate by doing trades pari passu across various client accounts – especially if the fund is in liquid markets? With a managed account the investors then have control over their money, so it is a lot harder to do any sort of monkey business.

The usual argument is the risk of transparency. In most hedge funds, I don’t buy it – especially if transactions are available for view only with a delay. In any case, my bet is that we will see more demand for managed accounts down the road.

Are we all a Ponzi scheme?
I suppose it is irresistible. If you are a columnist who has to find something to write about three times a week, latch onto the Madoff story with a metaphor to the growth of leverage by banks and individuals. Even intellectual luminaries like Paul Krugman and Thomas Friedman have gotten into the act.

But I don’t see the connection. With Madoff you have someone who is committing fraud. With leveraged investing you have people making investment decisions. Those decisions might not have been the right ones ex post, but a Ponzi scheme?

There is plenty to think about without straining that hard. Still, I don’t think we’ve heard the last of this.