Fri, December 12, 2008

World’s Biggest Ponzi Scheme Discovered

Septuagenarian Bernard Madoff has made his own special contribution to an extraordinary year.  His SEC-registered investment firm, which listed over 17 billion dollars in assets at the beginning of the year, is believed to be insolvent.  Estimates of the total amount of money lost to Madoff are as high as $50 billion dollars, although I haven’t yet been able to understand where that figure comes from.  What’s really significant about this scheme, beyond its size, is that many of its victims were the most sophisticated investors imaginable: hedge fund managers.

A Ponzi scheme is a fraud that begins when a swindler promises exceptional returns to investors; usually, the means by which returns are generated is obscure or even a secret.  For a time, the investment appears to succeed and “investment returns” are paid to early investors, but the returns are paid not from profits (there are none), but from money received from new investors.  In order to keep the scheme working, the perpetrator must constantly bring in new money.  Sometimes, investors help out by letting their profits ride, not realizing that the profits exist only on paper.  This kind of scheme usually can only be successful for a few years.  Eventually, the need to continually bring in larger and larger amounts of new money becomes unsustainable, and demands for payouts cannot be met.  When this happens, the jig is up.  It was probably inevitable that the market downturn and economic crisis would flush out some Ponzi schemes, but the magnitude of this one is surprising.  The fact that Madoff was able to operate his firm for almost two decades is surprising; it makes me wonder whether his operations might have initially been legitimate, but then drifted into fraud after he was unable to keep investing successfully.

Madoff’s investors included a number of wealthy long-term individual investors, but in recent years, the only way to for new investors to invest with Madoff was through hedge funds known as funds-of-funds. 

Supposedly, profits were generated using a stock option strategy called a “split-strike conversion.” In this investing technique, the investor buys a stock and simultaneously buys a put option on the same stock, giving him the right to sell the stock at a specified price.  He also sells a call option contract, granting someone the right to buy the shares from him in return for a premium.  When this strategy works properly, the investor is protected against downward price moves, but has the opportunity to profit if the stock increases in value.

Curiously, Madoff was also indirectly involved in a 1992 case in which the SEC went after two Florida accountants for selling unregistered securities.  For a decade, the pair had been taking investor’s money and giving it to a broker (revealed by the WSJ to be none other than Madoff) who invested it and generated impressive returns for several years.  The case turned up no indications that Madoff had profited from the scheme, except through his brokerage commissions.  The incident also probably contributed to Madoff’s reputation as an extraordinarily gifted investment manager.

Plenty of Warning Signs

Barron’s published an article on Madoff in 2001 that suggested that something funny was going on in Madoff’s investment firm.  In addition to noting that Madoff made a practice of asking his investors not to reveal to anyone that they were invested with him, the piece acknowledged that Madoff Securities’ performance record was extraordinarily good – too good, in fact, to be believed.  At that point, Madoff had operated for eleven years with only four down months, leading some investment professionals to become suspicious of him.  Over the past seventeen years, he claimed an annualized return of 10%.

According to today’s Wall Street Journal, Harry Markopolos, who formerly worked for one of Madoff’s competitors, has been trying to persuade the SEC since 1999 that “Madoff Securities is the world’s largest Ponzi Scheme.” Barron’s also noted in the 2001 article that the structure of Madoff’s firm was peculiar.  Although many of his largest clients were hedge funds charging 1% in fees and 20% of profits, instead of running a hedge fund himself, Madoff appeared to make his profits as a broker-dealer, charging no management fee at all.  By running the firm in the way that he did, Mr. Madoff appeared to be giving up hundreds of millions of dollars a year in fees.  When Barron’s inquired about this, Madoff replied “We’re perfectly happy to just earn commissions on the trades.” That, plus the money that he stole outright....

The Barron’s article observed that no one, including Madoff’s investors, could understand how he made his profits.  Some managers who invested with him became suspicious and pulled their money out when he couldn’t explain his performance; many others were happy to stick with him:

Still, some on Wall Street remain skeptical about how Madoff achieves such stunning double-digit returns using options alone. The recent MAR Hedge report, for example, cited more than a dozen hedge fund professionals, including current and former Madoff traders, who questioned why no one had been able to duplicate Madoff’s returns using this strategy. Likewise, three option strategists at major investment banks told Barron’s they couldn’t understand how Madoff churns out such numbers. Adds a former Madoff investor: “Anybody who’s a seasoned hedge- fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naïve.”

Now everyone understands that it was naïve to take Mr. Madoff’s performance at face value. 

It will be interesting to see whether this incident leads to further regulation of hedge funds, which typically operate under clouds of secrecy.  In this case, Madoff wasn’t even running a hedge fund – to all appearances, he was simply secretive about his trading strategy.  Despite questions raised by Barron’s and Harry Markopolos, the SEC’s routine audits of Madoff Securities apparently yielded no accusations of wrongdoing over the years.

There were plenty of things that were fishy about Madoff Securities, and some fund managers perceived them and decided to pass on working with him.

In my opinion, no one should put money into an investment without understanding how the investment generates its returns.  Moreover, if an investment strategy produce returns that run contrary to all reasonable expectations, that’s a dead giveaway that somewhere something is being missed.  This case, like others this year, demonstrates that even sophisticated investors can fall prey to the temptation to ignore the obvious – as long they’re making money.