Followers of the past year and a half’s financial misadventures have become inured to bucketfuls of red ink. Even so, the potential losses from the scam perpetrated by Bernie Madoff, a Wall Street veteran, are jaw-dropping. The $17 billion of investors’ funds that his firm supposedly held earlier this year have all but evaporated and the hole could be as big as $50 billion. That would make it the biggest financial fraud in history.
Details are still emerging, but Mr. Madoff has himself described it as a giant Ponzi scheme. For years, it seems, the returns paid to investors came, in part at least, not from real investment gains but from inflows from new clients. It might still have been going on, were it not for the global financial crisis. Redemption requests for $7 billion, by investors looking to pull back from turbulent stockmarkets, forced Mr. Madoff to admit that his coffers were empty — bearing out Warren Buffett’s adage that only when the tide goes out is it clear who was swimming naked.
The affair has robbed an embarrassingly long list of supposedly sophisticated investors of their swimwear. Hundreds of banks, hedge funds and wealthy individuals parked money with Mr. Madoff, impressed by the steady returns on offer: 10-15 percent a year, even in rough times, with barely a down month. Global banks such as Banco Santander, BNP Paribas and HSBC, all three of which had until now survived the credit crisis relatively unscathed, are among those reported to be heavily exposed. So too is Bramdean Alternatives, a fund run by Nicola “Superwoman” Horlick, a celebrated British money manager. Others had most or even all of their eggs in the Madoff basket. Several well-heeled Americans have reportedly lost everything but their properties.
Why were they not suspicious of the unnaturally consistent returns? Mr. Madoff’s pedigree may have played a part. A former chairman of the NASDAQ stockmarket, he has long been a fixture on Wall Street. He even has an exemption (to the former “uptick rule” for short-selling) named after him. He has served on an advisory committee assembled by the Securities and Exchange Commission (SEC), America’s main market watchdog. Savvy marketing was another factor. Investors had to be invited, lending his operation an air of exclusivity. This went down well in the country clubs of Florida, Minnesota and other states, where the firm’s unofficial agents told of Bernie’s magic touch, explaining that not anyone could get in, yet always somehow finding space for those who fancied a piece.
According to reports, some of those who put their faith in Mr. Madoff suspected that he was engaged in wrongdoing, but not the sort that would endanger their money. They thought he might be trading illegally for their benefit on information gleaned by a separate business within his group, which made a market in shares. The firm had been investigated more than once for “front-running”, using information about client orders to trade for its own account before filling those orders.
Even so, the affair has — like the subprime-mortgage debacle — exposed a stunning lack of due diligence. Droves of investors who should have known better tossed in billions, preferring to keep their fingers crossed rather than ask awkward questions of a firm whose investment strategy was vague and opaque. Even within his own group, Mr. Madoff’s money-management business was a black box: no one but he had full access to the accounts. As a broker-dealer, it was able to clear its own trades, a privilege that should give pause for thought. Worse, questions had been hanging over the operation since the mid-1990s. Some institutional investors have long steered clear of Mr. Madoff, unable to understand how he spun his gold, or uneasy that his books were audited by a tiny, three-person accounting firm.
The SEC, which seems to have been taken aback by the scale of the malfeasance, can hardly hold its head up high either. It did not get round to examining the books of Mr. Madoff’s money-management business, even though he registered it with the commission in September 2006 — though it did probe the market-making arm and found that it had violated some technical rules.
For an agency that is fighting for its life, that is unfortunate. Even before this scandal the SEC was on the back foot, having stood by as the big Wall Street investment banks it was charged with policing ran amok. In its defence, the commission argued that its primary role was investor protection, not prudential regulation. Now it has been shown wanting in its core competence — though, with 11,000 fund managers to oversee, not to mention the boom in mortgage-related cases, some may think it inevitable. Congress is next year expected to revamp America’s dysfunctional system of financial regulation. One option, already proposed by Hank Paulson, the outgoing treasury secretary, is to fold the SEC’s responsibilities into a new set of agencies.
The sloppy regulators and credulous investors whom Mr. Madoff duped must now hope that he has pulled off one last deceit: exaggerating the scale of the losses. Even in these accident-prone times $50 billion sounds like an awful lot for one man to lose. But it is just about possible if he levered up his bets with borrowed money or supercharged them with derivatives (which he is known to have used to reduce volatility). But even if the fraud extends no further than the $17 billion under management, it will go down as a humdinger. Indeed, it makes Charles Ponzi’s promise in 1920 to double investors’ money in three months — which caused losses equivalent to around $160 million in today’s money — look like a trifle. Perhaps from now on it should be known as the “Madoff scheme.”