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December 21, 2008

Madoff with Ponzi - Twin Devil on the Wall

We are yet to digest the sub-prime horror, international terrorism after Mumbai massacre and suddenly the trans-atlantic media is buzzing about a man and his master weapon- that's right, Mr Madoff & his schemy scheme , "Ponzi". With Wall Street reeling under $50 billion collateral damage, losses pouring in from Europe & parts of asia, some of the brightest investors' money under drain, this scandal has opened up the pandora's box of plight of super-free capitalist market. As the whole story yet to unfold, the big question that comes first- "What went wrong? Who is this Madoff? What is this Ponzi scheme? How come big names in the losser list got stumped by this NY man?"

Before we jump to any conclusion, let's understand this man and his strategy.

"Ponzi Scheme" is a fraudulent investment strategy where an existing investor is paid high short term return with the principals flowing from other new investors. So simple in explanation and so vast in its consequences. In order for this scheme to work, there has to have steady flow of investment to the fund, thus more new investors. Such strategy, which has its existance from 1920s, can easily be leveraged by a private fund house, hedge funds which are immuned to regulations.

Now, who is Mr Madoff? Few months back, this name would have raised standing appreciation for the level of contribution of the person - "Ex-chairman of NASDAQ, esteemed member of SEC, founder of Bernard L. Madoff Investment Securities, a firm which is outperforming market in terms of steady juicy return to investor in this drowning economy". Not any more.

Madoff's broker-dealer firm has its investment advisory arm which runs a massive fund house (with AUM $17 billion as quoted in public sphere) with a well-known option trading strategy called, "Collar" - that means short Call, buy Put, considered to be safest in capital market fraternity. Such strategy is deemed to suceed provided the strategist has the knack of time - when to get into market & when to come out. Since his fund was performing relatively better in this choppy market, investors(mostly big banks, fund of funds, ultra-rich individuals, charity organizations) were lured to join this exclusive black box of Madoff. With dollar dividends coming at ease, none of the investors ever scrutinized or questioned this man having distinctive background. And now, they all marred in the quagmire of Ponzi. Madoff never disclosed his investment strategy in public media nor explained that in investor reporting. He was equally illusive to regulators with very minimal disclosure, being a private broker-dealer / hedge fund manager. His stature remained tact since his stream of investors are not mass- market individuals, rather exclusive club of luminaries built on his rapport and personal relations (smells hedge fund, is n't it).

Then, what was his real strategy?

  • Build an exclusive club of investors through his circle of friends
  • Build the fund house framed on Ponzi structure
  • Limited regulatory liability being a private firm (again, hedge fund disclosure doctrines are non-existent). SEC even could not find any clue to possible fraud charge in 2006.
  • Exclusivity of investor club and steady return kept fradulent scheme suspicion at bay.
  • Maintained utmost secrecy on his investment to his closest executives & employees

All split open when he faced with massive redemption pressure (around $7 billion) from investors and then he starting disclosing the real scheme to his sons- close executives in the firm. Though it is premature to conclude on the whole fiasco, but it does raise eyebrows on certain market players who are really free, arogant- hedge funds, PEs and the regulations they are tied to till now.

  • SEC regulations on hedge fund industry is abysmally low - Madoff has thrived because of that. With no information on his investment details, regulators are equally blinded on the whole story.
  • Limited disclosure to investors - Hedge funds being considered to possess exclusive investment strategy which are not to be shared openly, investors in those entities blindly believe and rarely questions the nitty-gritty of investment strategy and underlying risk. That's where again Madoff has maneuvered his investor group / family.
  • Investor callousness- When dividend outsmarts market in this southward economy, investors were happy to count dollars than questioning the authenticity. Madoff's fund has neither details available at SEC nor Financial Industry Regulatory Authority (FINR).

To summarize, hedge funds, PEs and other private market participants are having ball time due to limited or zero disclosure requirements, no stipulations on risk based capital reserve. And the consequence is what we are seeing in Madoff fund and what we have already realised in the case of LTCM (1998) & Amaranth (2006). Present credit crisis demanded a lot of discipline from these folks on short-selling, liquidity management, but very less on disclosure on investment, risk tolerance. Time has come for SEC & other regulatory bodies to buck up and rein in those financial guerrillas on market & investor disclosure norms and risk-based capital reserve stipulations as practiced in banking industry. My fellow blogger Richard Wilson has provided a comprehensive analysis on this issue as well as on the present & impending regulations in hedge fund industry(here), however I am not sure how much he agrees to my introspection on this industry- so, opening this debate to larger audience for comment.