More On Bernie Madoff's Fraud & Its Reprecussions

I wrote a prior post concerning the Bernie Madoff investment fraud last week, here.


Since last Tuesday, more stories have circulated detailing the enormity of the losses among many wealthy individuals, charities, trusts, and institutional funds.

Daniel Henninger of the Wall Street Journal offered a comparison between Madoff's spreading scandal and a recent off-broadway play, "The Voysey Inheritance." It's an interesting reflection on the response of people to such large, outright fraud.

However, I wrote in my prior post,

"I guess, for me, the most amazing stories in the Madoff mess are those once-wealthy people who failed to diversify, and basically gave all of their wealth to Madoff to invest. I don't know the details of Madoff's operation, but, from my time as a registered fund manager, I know that there are safeguards required to prevent the easy looting of client assets in cases like this.

For instance, in the case of private accounts, a custodian institution is usually used. It's not clear if such an arrangement was in force for Madoff's clients. Another typical safeguard is a quarterly statement of holdings in individual accounts.

If these were not used, it shows incredible gullibility on the part of so many wealthy people. If they were, it suggests that Madoff had a lot of help, since these would have been fraudulent statements."

We don't yet know the extent of help and complicity that Madoff had with his scheme, with the probable exception of his wife. But as I discussed this matter with friends in the investment business this weekend, we all agreed that, to concoct and maintain such detailed records of fraud for so many individual accounts, Madoff must have had quite a bit of assistance.

It's inconceivable that Madoff's confederates or minions would have thought nothing of hand-entering so much portfolio position data each quarter, rather than it being generated from existing position statements driven by custodian or brokerage account statements.

To me, the key observation, which I read in the Journal last week, was that an outside analyst had done a sort of 'back of the envelope' calculation to determine that Madoff's portfolios, according to estimates of the assets he ran being in the tens of billions of dollars, must have had trading activity exceeding the entire market for various index puts or calls. Additionally, experienced clients seemed to think nothing of the fact that blue chip equities showed no decline in prices earlier this year, although they were key to the alleged strategy.

This smacks of convenient denial of reality by so many clients. The suspension of disbelief, and a desire to simply believe that unbelievably good, and not just consistently, but uniformly constantly good results, were real.

As I reviewed the mechanics of Madoff's scheme of undisclosed numbers of individual accounts, rather than a single, explicitly-spotlighted fund, with my partner, my belief that Madoff had long ago discovered loopholes that I, too, observed earlier this decade grew significantly.

The most important element of his fraud, without question, was the lack of independent custodial inventory reports of financial assets held in accounts for clients. I can't emphasize enough that this alone left every one of Madoff's clients vulnerable.

Coupling this with a curious lack of diversification, a/k/a greed or stupidity, and you have the recipe for disaster among so-called 'sophisticated' investors.

Many years ago, during the WPPSS bond collapse, I read articles in the Wall Street Journal detailing the loss of entire life savings of many very average Americans. People had actually invested entire retirement accounts into just this one instrument, only to see it fail utterly and become worthless.

At the time, I posited a very personal belief that, for most people, simply reaching retirement with their principal intact is probably better than average performance. Never mind the 10% annual S&P average return, or something more like 3-6% if someone invested in a mix of assets and traded heavily.

Just staggering across the financial finish line with what you saved, while avoiding egregious market downturns, frauds, and other widespread investing pitfalls, was probably an exceptionally good performance.

Madoff's clients now add substantial evidence for my viewpoint. How many once-wealthy Americans having millions of dollars of accumulated financial assets are now simply bankrupt? Or nearly so, with almost nothing to show for decades of successful careers?

And all of this....all of it...would have been minimized, if not totally avoided, had each and every investor insisted on receiving a regular asset inventory report from an independent custodian. This would have prohibited false claims of asset ownership, or required an entire custodian's business to be in league with Madoff.

I don't believe any more regulations will prevent a repeat of this type of periodic investment fraud. There are plenty of safeguards required by current regulations. But nobody can prevent a person from simply throwing caution to the winds, trusting in a manager, and his 'special' inner client circle, without any objective, confirming evidence.

As I described to my friends over coffee on Saturday, you can run hundreds of individual investment accounts as an unregistered investment manager. Sure, the legal maximum is between 15 and 30. But so what?

If you choose your clients carefully, and never let on that you actually have hundreds of them, and they don't all meet, who would know? If none complain to the SEC, why would that agency bother you?

If, as in a proper Ponzi scheme, you cash out any disgruntled investors, so they have nothing to take to the SEC by way of losses or evidence of malfeasance, there's simply no way of being discovered.

It's a lot like being shot by an illegal firearm. Sure, we have complicated laws restricting lawful access to these weapons. That only means you are more likely to be shot and/or killed by an unlawfully-obtained weapon, rather than a lawfully-obtained and carried piece. You won't be less wounded, or dead.

And more laws won't actually prevent illegal guns from existing. Nor illegal investment management schemes, either.