Bernard Madoff and his little Ponzi…
Bernard Madoff’s feat is nothing short of spectacular. His scheme was impressive not only for its final total – estimates range from 25 Billion to 50 Billion of fraudulent loses ! but also for its strong marketing approach. Most Ponzi or pyramid structures promises high returns to all comers, Charles Ponzi himself promised profits of 50% within 45 days, facilitating their detection. Unfortunately, B. Madoff did perfected the pace and marketing of his little Ponzi…
The Pace
His approach was to offer good, steady returns to an exclusive clientele. The decent returns lowered the guard of many, and their regularity, even during bear markets, made his reputation. This steadiness did ring a few bells. Yet they did not act earlier. Maybe it was thanks to B. Madoff’s marketing
The marketing
To those who questioned the scheme, the basic answer was that such feat was possible through a combination of index-tracking stock purchases, hedged with related options. Of course, the exact details were kept secrets… Those who asked too many questions were simply given their money back and shown the door.
As with all Ponzi, this strategy was very efficient because the loss of a potential steady profit made other clients think twice before asking questions. Additionally, B. Madoff clientele were very exclusive and most were referred to him by friends. Being kicked out of his scheme could be compared to a social rejection.
Last, but not least, Madoff’s scheme also differed in that some hedge funds also invested with him. Their clients expected them to diversify their portfolio and protect them against the market aleas – in search or the infamous Alpha – and were willing to pay expensive managements fees for their expertise. Most did not know they were exposed…
2008 as a revelator
The credit crisis and difficult market in 2008 forced many to cash out their positions. Madoff struggled to honor them until the end of 2008. By then, too many had done so at the same time, and the scheme collapsed due to a lack of liquidity.
Now what?
Markets’ ability to operate demand a strong confidence in the system. Without it, we would never accept paper payment, online trading and other modern marvels. The real feat or B. Madoff’s scheme, aside from working so well for so long, is the long lasting impact it will have on the financial circle of trust. The general public will think about it twice before investing their hard earned money, markets and hedge funds are going to face difficult times, security committees are going to be extra vigilant. All in all, not a bad thing if we learn from it. We should end up with a cleaner system.
The real question I still have is this one: Why is he not in Jail yet?
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Could anyone have spotted the red flags if they’d known where to look? Could a little diligent research and a more careful strategy have prevented this fiasco? Maybe, but unfortunately herd mentality is not an investment strategy and hindsight is 20/20. And when wealthy investors rely on advice from friends over country club cocktails with no questions asked, it’s a set up for disaster.
Madoff knew how to play the game, to charm his victims, foster relationships of trust, and then reel them in. In some circles, he was considered a rock star—able to sell himself to European investors by indulging them in his favorite hobby: snow skiing. He had the aura of running an exclusive club that frequently turned some away at the door.
There are certain basic due diligence practices which investors should follow before giving their money to any financial advisor or principle involved in publicly traded securities—practices like reviewing a company’s financial statements
and other regulatory filings, and knowing the right kinds of questions to ask about the management team, the underlying business practices and the integrity of their accounting firm.
But Madoff had a particularly complex structure that shielded him from such scrutiny. Most of his supposed transactions were related to hedge funds, which are not regulated by government agencies. To make matters even murkier, Madoff Investment Securities, the entity under which he operated, was both the broker dealer and investment advisor.
That meant he was trading in the same securities that he recommended to advisory clients, and on top of that he actually had custody of the assets. Large, credible accountants are supposed to ensure that a company’s books are clean, but Madoff was using of a small auditing firm, Friehling & Horowitz, which has only one active accountant.
In his non-hedge fund-related transactions, there were suspicions raised when Madoff's company avoided filing disclosures of its holdings with the SEC by selling its holdings for cash at the end of each period.
When you can’t rely on the standard resources available for doing due diligence on publicly traded securities, here are a few common sense tips to keep in mind.
• Herd mentality: If it’s good enough for them, it must be good for me
If someone gives you a tip, never assume that they have asked all the right questions. Ask all the questions yourself, and if you don’t even know what the questions are, let that be your first clue to go no further.
• Trusting smoother talkers
Madoff was apparently a slick actor. He kept everything shrouded in secrecy thereby creating an aura of exclusivity. Never assume that what you see is what you’re going to get.
• Foregoing personal responsibility
If you can’t assume responsibility for how your money is being invested, you have no business investing, or speculating. And if you invest with anyone who claims to never lose money, reports consistent earnings for 20 years despite exceedingly volatile markets, will not explain his strategy, refuses to disclose even the most basic information or discuss potential risks, you're not investing, you’re not even speculating, you’re basically throwing your money away.
There were plenty of red flags, but they were all ignored. If you need further evidence, be sure and read theletter that Harry Markopolos sent to the SEC.
If there's one thing we should take away from this scandal, it's to take control of your own financial dealings, be wary of anything you don't fully understand and, if you are asking financial advice, make sure you understand what motivates their advice. The so-called “experts” like financial advisors, brokers and accountants are not infallible. Neither are your well-meaning friends. Do your homework!
Very good conclusions Jose.
This is why websites like http://www.fool.com and other are so important.
They will ensure more transparency.
Unfortunately no one can ever be 100% safe from a Madoff like affair. His structure was complex enough to fool even big players like Santander or HSBC which are known for their conservative and risk-averse approach.
Very good conclusions Jose.
This is why websites like http://www.fool.com and other are so important. They will ensure more transparency.
Unfortunately no one can ever be 100% safe from a Madoff like affair. His structure was complex enough to fool even big players like Santander or HSBC which are known for their conservative and risk-averse approach.