Tag: Madoff

Weekend Watching

You may have missed Madoff on ABC this week. It’s four hours on the life of the fraudster, portrayed by Richard Dreyfuss. If you have a few hours this weekend, it’s worth watching.

madoff

Mr. Dreyfuss does a great job portraying Madoff, capturing him lying, cheating and stealing, but looking upstanding in the eyes of his investors. A con man in a fancy office. He nails it.

Blythe Danner is even better as Ruth Madoff, enjoying the luxuries of life and clueless about her husband’s deception. Then she is torn when her sons make her choose between them and Bernie.

Frank Whaley is over the top as Harry Markopolos. He is portrayed with an extra bit of lunacy spewing out indecipherable phrases to the SEC about uncovering Madoff’s fraud.

I didn’t like how the movie painted a stark line between the legitimate Madoff brokerage and the fraud in the management side. The main trading floor is full of rich furniture and decoration. The fraud center on the 17th floor is a smoke-filled, windowless den of iniquity. Why are there no windows? (There were windows.) Michael Rispoli, as Frank DiPascali, is straight out of the Sopranos. The rest of the fraud crew are poorly dressed and unkempt, while the trading floor remains beautiful.

The show also fails to show much of the greed of the feeder funds who were happy to take big management fees while Madoff was content to live off the brokerage fees. There is one pair of fund managers who nearly jump with joy when they find out the arrangement.

The movie also fails to add the color that many investors thought Madoff was cheating. But they thought he was front-running trades in the brokerage. That group of investors was happy to have their money with a cheater, as long as he was cheating someone else and not them.

How Do You Exit a Ponzi Scheme?

Charles Ponzi

It looks like Bernie Madoff was $45 billion short of funds in his “investment strategy.” How was he ever going to get out of this?

The original Ponzi schemer, Charles Ponzi, seems to think he could get out of his situation, at least according to Mitchell Zukoff, author of Ponzi’s Scheme: The True Story of a Financial Legend.

It sounds like Madoff and Ponzi fell into the same trap. At some point early on they did not realize their promised investment goals. Instead of being honest with their investors, they posted a fake return. The hope was that they could make up for the miss later on.

The central characteristic of a Ponzi scheme is that current returns to investors are paid from new investments instead of a return on the invested capital.

The duration of a Ponzi scheme is dependent on a few factors.

The first factor is the promised return rate. The higher the promised return the shorter the duration. One of the reasons Madoff continued for so long is that his promised return was typically low. He was generally in the 15% range. Since Ponzi was promising returns of 50% in three months, he had a short fuse on the length of his scheme.

The second factor is the redemption rate. The promised return is only meaningful when you have to pay out cash. The better the schemer is at getting investors to keep rolling over returns, the longer the duration. Madoff was undone by the 2008 financial crisis, crushed by a wave of redemptions as people were desperate for cash.

The third factor is the investment rate. The better Ponzi schemers can keep the cash flowing in. As long as the investment rate of cash flowing is in excess of the redemption rate, the scheme will not collapse unless discovered. Once the redemption rate exceeds the investment rate, the schemer will not have the cash to make payouts and the scheme will likely be discovered.

The fourth factor is discovery. This is a wild card. Once an accusation of fraud is made, there will likely be an sharp increase in the redemption rate and a reduction in the investment rate. Ponzi has high profile and attracted attention. Madoff was very secretive. If you can’t stand up to scrutiny, the less scrutiny the better.

The fifth factor is actual returns. I would theorize that many Ponzi schemes start as a legitimate investment proposals. So there may be some actual investment returns that could offset the need for a higher investment rate. Ponzi never made a legitimate investment so this factor was zero for his scheme. Madoff was apparently investing legitimately at some point, but ended up at zero for many years leading up to the collapse. Stanford was generating returns in his banking empire. Just not enough.

The obvious exit is to increase the actual returns to meet the promised return rate before the redemption rate exceeds the investment rate. You can look at Sam Israel who seemed to think he was always just a few trades way from making back all of the promised money.

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The Monsters of Compliance – Dracula

dracula and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Vampires have taken many forms, mixing mythologies, weaknesses and desires. There is the regal version played by Bela Lugosi, the tortured soul of Angel, the vicious version played by Christopher Lee, the superhero version of Blade, the numerology of Count von Count, and the delicious Count Chocula. (Vampires don’t sparkle.)

Dracula has remained as the most vampirish of vampires. Unlike lesser vampires, Dracula glows with a veneer of aristocratic charm. He has supernatural strength, the ability to charm you into doing something you don’t want to do, and perhaps the ability to turn into a bat. With all those strengths come many weaknesses: crosses, holy water, garlic, and daylight. He would seem easy to defeat if he were not so charming.

When trying to draw a compliance comparison, one person came to mind when I thought of the Count: Bernie Madoff. His charm was his power, leading a flock believers, while all long he sucked the life out of them. He drained their money for his own use. It was daylight that killed hill. He pulled back the curtain of secrecy and exposed his operations to the sunlight. All of the wealth and all of the power turned to dust.

Ponzi schemers are the vampires of compliance. It’s relatively easy to repel them with a few splashes of garlic flavored due diligence. But once under their charm, they drain you. The Securities and Exchange Commission can try to swoop in like Van Helsing, but by then the ponzi scheme will have already claimed some victims.

Lance Armstrong – A Lying Liar Just Like Madoff

sad lance armstrong

It’s tough to see a hero fall. I didn’t consider Lance Armstrong to be a hero for riding. But what he did for cancer survivors was remarkable.

Until recently, cycling was filthy with doping. Take a look at the podium finishers for the Tour de France. Only two of the podium finishers in the Tour de France from 1996 through 2005 have not been directly tied to likely doping through admission, sanctions, public investigation or exceeding the UCI hematocrit threshold. The sole exceptions are Bobby Julich – third place in 1998 and Fernando Escartin – third place in 1999.

I could forgive Armstrong for doping. It seems clear that everyone was doping. It leaves open the question of whether Armstrong was one of the greatest cyclists or merely one of the greatest dopers. We have no way of knowing whether his regime of doping merely leveled the playing field or elevated him above the level of his also doping competitors. Were his competitors lesser cyclists or merely less capable at doping?

What caught my attention about the Armstrong interview was the window into the mind of a pathological liar. Armstrong had been telling the lie over and over and over. He lied to the public. He lied to the press. He lied to cancer survivors. He lied under oath.

Beyond that, he attacked those who accused him of doping. He ruined the careers of journalists who dared accuse him of doping. He ruined the careers of riders who accused him of doping.

I put Mr. Armstrong in the same group as Bernie Madoff. Two men who lived their lies for decades. They both seem to regret that they got caught, not that they were lying and stealing money. Granted Mr. Armstrong’s theft was a bit more indirect.

I don’t believe most of what Mr. Armstrong told Oprah in the interview. He’s been lying too long to think that he is now telling the whole truth. But there may be bits of truth mixed in his interview. He did clearly admit to doping.

As with most pathological liars, Mr. Armstrong expressed more remorse that he was caught, than for the harm he caused. He found justification for his bad acts.

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The Echoes of Madoff at the SEC

The Madoff scandal is one of the low points in the history of the Securities and Exchange Commission. Every Congressional hearing or SEC-basher inevitably uses the failure to catch Madoff as evidence of the ineffectiveness of the SEC.

In a continuing journey down the rabbit hole, the SEC’s Inspector General David Kotz released his 123-page report (.pdf) on former SEC General Counsel David Becker and his involvement with Madoff. Kotz has made a referral to the Department of Justice under a criminal conflict of interest provision.

Mr. Becker’s late mother had an account with Madoff. If Mr. Becker were to be involved in mopping up the Madoff matter, there would be potential conflict of interest.

David Becker seems to have done the correct thing. He sought an answer from the SEC Ethics Counsel as to whether he should work on Madoff matters.

“I did precisely what I was supposed to do. I identified a matter that required legal advice from the SEC’s Ethics Office. I sought that advice, received it, and followed it.” Testimony of David Becker September 22, 2011

He fully disclosed the fact that he had been a beneficiary of his mother’s estate which had invested in Madoff funds. The Ethics Counsel told him he did not need to recuse himself. His boss, SEC Chair Mary Shapiro, knew of the investment.

Nonetheless, the SEC’s Inspector General is referring its results to the Department of Justice for criminal investigation.

Personally, I don’t think Mr. Becker actually did anything wrong. I believe he joined the SEC as a white hat, wanting to resume his role in public service.

The problem is that it looks like he did something wrong. That’s the problem with conflicts of interest. Even if you do the right thing, it will look like you were improperly influenced or tainted.

Becker did seek guidance from the SEC’s Ethics Counsel. Unfortunately, the Ethics Counsel is part of the Office of the General Counsel. As General Counsel, Becker was the advice-giver’s boss. Another conflict.  I’m not saying that Becker actually unduly influenced the Ethics Counsel. It’s just looks bad and layers another conflict of interest onto the existing conflict of interest.

The SEC knew that Madoff was toxic and high-profile. They should have been more vigilant and not allowed Becker to participate. I would guess that Becker was so good at his job and so enthusiastic to help that he and the SEC failed to see his weaknesses. It would be hard to make him sit on the sidelines while the Commission was trying to clean-up after one of its biggest failure. But that is what they should have done.

They let the conflict of interest stay in place. That should have known that it would subject them to a later review and attack on their decision to keep Becker involved. They should have known that it would have led to something like the Inspector General’s report.

I don’t think Becker should be subject to criminal charges and hopefully the Department of Justice will drop the matter after a brief investigation.

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Is Madoff a Sociopath?

The New York magazine interview with Bernie Madoff has finally been published.  Steve Fishman spoke with Madoff on the phone (collect calls from Madoff’s prison) for several hours.

And so, sitting alone with his therapist, in the prison khakis he irons himself, he seeks reassurance. “Everybody on the outside kept claiming I was a sociopath,” Madoff told her one day. “I asked her, ‘Am I a sociopath?’ ” He waited expectantly, his eyelids squeezing open and shut, that famous tic. “She said, ‘You’re absolutely not a sociopath. You have morals. You have remorse.’ ” Madoff paused as he related this. His voice settled. He said to me, “I am a good person.”

There aren’t many who would agree.

According the the interview, Madoff was already a wealthy man before he starting stealing from his clients and lying about their investments.

In the early days, Madoff mostly employed technical and fairly low-risk arbitrage techniques built around his market-making business. “I always had a good feel for the direction of the market because of the order flow I was seeing,” he said. In the eighties, he said, he produced consistent returns of 15 to 20 percent, and he insists he did it legally.

To me it sounds a bit like he was taking advantage of his trading business to help out his investment advisory business. Madoff had long been suspected of front-running trades to make money for his advisory business.

In the interview, he claims that the fraud started after the crash of 1987. Clients pulled out capital and he was forced to unwind long-term hedges on unfavorable terms. Then his trading scheme was no longer working because the market lacked the volatility needed for his arbitrage. And because trading spreads were narrowing because of the rise of electronic exchanges.

In the interview, Madoff displays some of the classic criminological behaviors of a fraudster.

He blames his victims: “Madoff says that he waved red flags, issued caveats that should have been obvious to even an unsophisticated investor.”

He denies his victims: “Everyone was greedy,” he continues. “I just went along. It’s not an excuse.” “Look, none of my clients, even if they lost every penny they put in there, can plead poverty.” In the tapes he claims that very few of the early investors will have lost their invested capital.

He condemns his condemners: “The whole new regulatory reform is a joke. The whole government is a Ponzi scheme.”

He claims everyone else is doing it: “It’s unbelievable, Goldman … no one has any criminal convictions.”

I think Madoff’s prison therapist told him the wrong answer. Or Madoff lied to Fishman about the therapist response.

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Save Your Company, Save Yourself

What happens when you have a business disaster on your resume? Maybe listing an Enron or WorldCom would not be so bad. Those companies are big enough that you may not be tainted by the corporate fraud. Unless you ended up in handcuffs.

As the company gets smaller, you’re more likely to get caught in the stink of corporate fraud. That gets even worse when you share the last name on the door.

The Wall Street Journal highlighted the lack of future job prospects with former Madoff employees: Not Exactly a Résumé Highlight: Madoff Work

The story focuses on the Madoff sons, Mark and Andrew, who are labeled as being “untouchable in any firm that deals with the public.” I am not surprised that they are unemployable. Would you hire a Madoff?

But the scar of the fraud falls farther down the corporate ladder. Eleanor Squillari, Bernard Madoff’s former assistant, has moved on to cosmetology. She knows she’ll “never get a job in finance.”

The trading business, which was not implicated in the Madoff fraud and was purchased by Surge Trading, Inc., has the challenge of convincing clients to do business with former Madoff employees.

I suppose the upside is that company schwag could turn into collector’s items.

The New Face of Evil?

The New Face of Evil?

His crime was simple: collect money from investors, fake the returns, pocket the money, and repeat. His crime was the biggest: $20 billion in cash plus $45 billion of fake returns.

Should Bernie Madoff be the new name for evil? Christine Hurt of University of Illinois College of Law contrasts Madoff with the original Ponzi schemer, Charles Ponzi himself.

Judge Chin at the Madoff sentencing cast him with the label of evil:

Here, the message must be sent that Mr. Madoff’s crimes were extraordinarily evil, and that this kind of irresponsible manipulation of the system is not merely a bloodless financial crime that takes place just on paper, but that it is instead, as we have heard, one that takes a staggering human toll

His 150 year sentence is a staggering sentence for a non-violent crime. Financial fraud sentences are rapidly increasing in length and severity.

Perhaps, as Hurt point out, this increase in penalty is a reflection of the American society. We are now more afraid of outliving our retirement savings than of home invasion. (But not of people taking pictures of planes.)

Unlike the complexity of the WorldCom and Enron financial misdeeds, Madoff’s were much more straight-forward. It’s an easier story to tell the judge. It’s easier to lay the blame. Bernie kept his mouth shut and did not implicate anyone else.

We are already seeing the “Madoff” label being applied to other fraud schemes. Kenneth Starr’s fraud is being labeled “Madoff-Like.” other frauds are being called “Mini-Madoff.”

Maybe the Madoff label will stick.

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Dealing with Losses From the Madoff Fraud

Charles Ponzi

One of the many repercussions of the Madoff fraud is how to treat investors who had money in his Ponzi scheme.

There has been plenty written about how the trustee is treating the direct investors. He is only treating net cash. If you took out more cash than you put in, you are on the hook. That is regardless of how massive your paper losses may be. This clearly hurts the early investors with Madoff.

The other aspect is how the feeder funds or other investment funds treat the losses and pass them through to their investors. The case of Beacon Associates caught my eye when it popped up. (There is no connection to my employer.)

Beacon Associates had placed a big chunk of its assets with Mr. Madoff. That has lead to a class actions suit by its investors and ERISA lawsuits.

The losses have also left the fund in the lurch as to how to treat the losses and which period to attribute the losses. Between 1995 and December 2008, Beacon issued monthly financial statements reporting substantial gains on Beacon’s investments. Beacon allocated those gains to its members in proportion to each member’s interest in Beacon and reflected those gains in its financial statements. As we have now discovered, Madoff never invested the capital and those gains allocated by Beacon never existed.

As a result, Beacon ended up commencing liquidation and needed to figure out how to distribute its remaining assets to its investors. Beacon lost approximately $358,000,000 through investments with Madoff and had just $113,283,785 of remaining assets.

One way to treat the loss is the valuation method. You treat the losses to have occurred on December 2008 when the Madoff fraud was uncovered. Any investor who was fully redeemed before then would not be allocated any loss.

An alternative treatment would be the restatement method. They would treat the losses to have occurred when Beacon made each of its investments with Madoff. That would allocate the Madoff losses over a much longer period of time.

Not surprisingly, the different methodologies “provided dramatically different results.” While the capital account of one member was calculated at $4,750,866 using the Valuation method, it had a balance of $2,735,636 under a Restatement method. Another member’s capital account was valued at $1,815,576 under the Valuation method, but exceeded $3,000,000 under a Restatement method. Beacon polled its investors. Eight-two percent preferred the Valuation Method, 10% preferred a Restatement Method, and twenty-five (8%) did not make a selection.

The court ended up ruling:

“Because Beacon’s Operating Agreement requires that capital accounts be maintained in accordance with Federal Treasury rules, and because the IRS has ruled that losses attributable to Ponzi schemes be reported in the year they are discovered, Beacon’s Operating Agreement must be read as requiring that Madoff theft losses, including those losses owing to “fictitious profits,” be allocated among its members’ capital accounts in proportion to their interest in Beacon as recorded in December 2008, when Madoff’s fraud was discovered.”

The net investment method is similar to the one being used by the Madoff and is appropriate for Ponzi scheme cases. Here, the court points out that Beacon itself was not a Ponzi scheme. The valuation method is the proper choice.

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Madoff Losses Down from $65 Billion to $20 Billion

How do you value fraud?

When the Madoff ponzi scheme collapsed the claim was that there was $65 billion in losses. That was the total dollar value on the account statements given to investors. Of course, that number was fictional because there were not real assets behind those numbers.

The trustee overseeing the liquidation of the assets looked at the cash that came into Madoff and the cash that came out. The bankruptcy judge agreed. In a decision filed on Monday, Federal Bankruptcy Judge Burton R. Lifland ruled that losses should be defined as the difference between the cash paid into a Madoff account and the amount withdrawn before the fraud collapsed in mid-December 2008.

The Madoff trustee, Irving H. Picard, took the position that “the only verifiable amounts” reflected in the Madoff records are the differences between how much investors put into their accounts and how much they took out.

The result is that those investors who didn’t pull out their initial capital will get a greater percentage of their money out than those who took withdrawals from their accounts.

To put it another way, the people are getting the greatest percentage of money back are:

  1. Those who least need the money. Since they took less money out they presumably have other income or capital to support their needs.
  2. Those most trusting of Madoff.  Since they trusted Madoff, they did not pull money out of their investment accounts. They rode those returns and let their fictional returns keep accumulating.

Those who took out more cash from Madoff than they put in were labeled the “net winners” and get nothing. Even worse, it looks like the “net winners” may have to give back some of their “winnings” to the bankruptcy estate to pay off the net losers.

Of course, the opposite ruling is just as bad since the early investors would be paid by later investors, effectively extending the Ponzi scheme.

The judge is taking the position that people should be put back to their position as if they had not invested with Madoff. In the end its going to bad for all the investors. It’s just a question of who feels the most pain.

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