Madoff mystery

Bernard Madoff, the broker-turned-investment manager, in New York on December 17. He defrauded a number of investors, including banks, all of whom never sought to understand where the returns came from.-SHANNON STAPLETON/REUTERS

THE full details of the crisis triggered by sub-prime lending had just about been absorbed when the much-discredited financial system in the developed countries, especially the United States, was hit by another quake. This was the mid-December revelation that one more of the venerated Wall Street figures, Bernard Madoff, and his investment firm, Bernard L. Madoff Investment Securities LLC, had indulged in fraud on a massive scale, leading to losses estimated by Madoff hims elf at $50 billion.

While the details are still being investigated, reports suggest that the fraud amounted to a straight-forward Ponzi scheme, in which new capital raised was partly used to pay off old investors so that they could earn a stable and reasonable return, independent of fluctuations in the market. It was when Madoff could not continue doing this any longer that the plot was revealed.

When the markets slumped, investors sought to redeem their investments and new money was hard to come by, and the operation collapsed, resulting in bankruptcy and criminal indictment for Madoff and huge losses for his clients. According to reports, Madoffs secret had to be revealed when, in the first week of December, the company was faced with redemption requests for $7 billion.

As details of Madoffs operations are being unearthed, the main question being asked is how he managed to conceal their nature for so long. The story is a mystery for a number of reasons. To start with, Madoff seems to have defrauded a large number of investors, dull and savvy, large and small. In fact, at the time of writing, close to $22 billion of the $50 billion in assets that Madoff claims to have lost has still not been traced to investors.

Since Madoffs fund outperformed the market, the stable return he promised attracted a wide range of direct and indirect investors, who appear not to have spent too much time trying to understand the method that underlay his success. Investors varied from banks such as Santander, Bank Medici and HSBC to fund managers such as Fairfield Greenwich and Tremont Capital Management to pension funds of policemen in Fairfield, Connecticut, and teachers in South Korea.

Indirect exposure was large because there were a number of fund managers, who served as feeder funds for Madoffs operation, mobilising money from clients and transferring it to Madoff for investment.

That investors as diverse as these were simultaneously fooled for so long is all the more intriguing because some of them made huge investments. There are five identified investors with exposures of $1-1.5 billion, four in the $2.1-3.3 billion range, and one, Fairfield Greenwich, with an exposure of $7.5 billion, which is more than half of the assets of $14 billion it manages.

With such large investments and high exposure, one would have expected these agents to have scrutinised Madoffs operations and accounts closely. That they did not detect the fraud seems to suggest that the financial industry is not merely overcome with greed but is short of intelligence. Stable returns must be a cause for concern rather than the basis for comfort.

Apart from the stable and reasonable returns that Madoff offered, there were other more obvious reasons for investors in his firm to have been cautious. For instance, despite his high profile as a successful broker-turned-investment manager, Madoffs operations were audited by a small entity, Friehling and Horowitz, which reportedly employed just three persons and had not been peer reviewed for a decade and a half on the grounds that it does not audit any firm.

In addition, Madoff himself was known to be reserved and guarded about his activities. To choose to hand over millions or billions of dollars to an entity of this kind is downright foolish.

But it was not just individual investors who were foolish. Big banks set up feeder funds that mobilised capital to be invested through Madoff and also lent large sums to these funds so as to make leveraged bets on Madoff. Moreover, leading accounting firms, such as PricewaterhouseCoopers, KPMG and Ernst & Young, that audited these feeder funds did not detect the fact that Madoffs operations were, in his own words, one big lie. Those who were fooled included some of the best in the business, those who are normally presented as being too well informed and too savvy to indulge in speculative investments without knowing that they are doing so.

Not everybody was fooled, of course. Deborah Brewster of Financial Times (December 12, 2008) quotes Thorne Perkin, a vice-president at Papamarkou Asset Management, as saying: In the past few years at least half a dozen smart, sophisticated people have come to us and asked about investing with Mr. Madoff. We looked into it and didnt invest mainly because we could not understand how the returns were arrived at, and we do not recommend investing where we cannot work out where the returns come from. But such advisers seem to be more the exception than the rule.

This only strengthens the view that financial markets cannot be left to themselves on the grounds that they know best and those seeking to regulate these markets and institutions cannot be equally well informed, making self-regulation the better alternative. The Madoff scandal is not only one more confirmation that the so-called model financial markets of the U.S. are neither transparent nor efficient but also proof that so-called savvy investors can either be thieves or fools.

This would not matter so much if their activities and their effects were confined to a private world of the rich. But if the ripple effects are felt economy-wide, either directly because of the exposure of institutions such as pension funds or indirectly because of the systemic effects (transmitted through excessively exposed banks and corporations) of the failure of institutions such as Madoff Investment Securities, regulation recommends itself.

Unfortunately, the Madoff episode is one more indication of the adverse consequences of diluted regulation. Christopher Cox, the chief of the Securities and Exchange Commission (SEC) in the U.S. has been quoted as having confessed that over a period of several years, nearly a decade, credible information was on multiple occasions brought to the agency, and yet at no point taken to the next step.

Madoffs methods, which included maintaining false documents and disclosing wrong information, were not detected but were declared by Madoff himself. This despite the fact that the SEC reportedly launched investigations in 2005 and 2007 into the investment advisers operations.

Faced with criticism, the SEC has decided to launch an internal investigation into how its systems failed to detect the fraud. The difficulty is that even while there is recognition now of the need for intervention, the emphasis is more on intervention to reduce losses and limit systemic effects. There are no signs of commitment to fundamentally revamp or overhaul the regulatory system.

While everyone admits that the regulatory system has failed and that markets do not work well, the desire to design a regulatory structure that minimises failure seems to be absent. This can only be because financial interests are strong enough to win a bail out with taxpayers money and yet prevent adequate scrutiny and control.