Sunday, December 28, 2008

General Misperceptions of “The Madoff Affair”

I had not intended to devote another blog to what the French have called “The Madoff Affair” before securing additional perspective and information. However, recent writings and holiday party discussions have highlighted a lack of understanding about the workings of the investment world. In this context, I offer the following points which have not been covered in the press.

Bernie Madoff entered the brokerage world as a proprietor of an Over-the-Counter dealer in Puts and Calls, one of the first types of derivatives traded beyond the stricter rules of exchange-traded securities. The price spreads between the Bid and Asked at the same strike price (face value) could be quite large, as there was little in the way of competitive bids and offers at the same strike price. Much of the Put & Call business came from retail oriented firms who were incentivized to concentrate their business with one or more dealers by being paid for their order flow. Many of the Put & Call Dealers were attempting to lock in the spread. In order to get more people involved, dealers sold combinations of Puts and Calls, either in or out of the money. (Meaning at least one side of the trade approached profitability if it were not for the premium paid for the option.) If you find this description a bit hard to follow, so did the regulators, leading this portion of the market to be aptly described as the “Wild West.” Regulators did not have the appropriate tools or business knowledge to oversee Madoff’s activities.

Bernie learned his trade well. With the founding of the Chicago Board of Options Exchange (CBOE), the game changed as spreads narrowed and trades were recorded for all to see. Bernie adapted quite well. He used the payment for order flow approach plus a significant investment in some of the faster computer software and hardware available to earn a significant share in all principal markets in the country. Some people thought he substituted his own capital through the use of options to offset imbalances. If there was any such activity, I believe now, it was the use of his investment firms' orders that had the advantage.

Madoff created two separate firms according to function. The first and by far the largest in terms of employees and image was the old Put & Call firm, which was one of the country’s largest brokerage firms, trading a large share of orders, probably not volume. One of the key benefits of this arrangement was that the brokerage firm could act as a custodian for customer securities. Most investors are familiar receiving monthly account statements, though only recently have these reports included performance calculations. Many smaller, non-publicly owned brokers like Madoff, are only audited once a year, conducted by less prominent accounting firms, and publishing only a statement of financial condition, not a profit and loss statement. Except by sampling, individual accounts are not reviewed.

The second firm that Bernie Madoff created was a registered investment adviser. This was a very unusual firm in that it did not charge for its services. The given reason was that the combination of the firms would make its profits from the trading in the brokerage firm. (Perhaps this distinction may play a role in their legal defense. The courts will have to decide whether the investment firm actually gave advice to these brokerage accounts.

Apparently most of the money that was “managed” came in through what is called “feeder funds.” Feeder funds are a common way for hedge funds and offshore funds to receive capital indirectly. There has not been enough disclosure as to what multiple functions these feeder funds supposedly provided to Madoff. The range of possibilities include some or all of the following: (a) an introducer to a disclosed adviser or fund, (b) a purported fund of funds with only one sub-fund, or (c) a bank or brokerage firm providing leverage at the fund or account level. It will be the jurisdiction of the various regulators or courts to determine what functions were actually offered or performed, and who had what level of knowledge regarding fraud.

Undoubtedly the biggest misperception was that the investments could regularly produce, with very rare deviations or losses, a predictably performing vehicle capable of producing higher returns than bonds with less volatility than stocks. In the aftermath of the Tech Bubble, and the more recent liquidity/credit collapse, investors felt comfortable, indeed conservative, putting so much of their wealth into this wonder. How could they be wrong when so many of the most respected people and organizations in their world also invested knowingly in Bernie Madoff’s wonderful money maker?

Not enough time has passed and the disclosure has been too limited to draw conclusive lessons from this great tragedy. Two lessons are of paramount importance: First, that diversification should be an absolute requirement for all portfolios, particularly institutional accounts. Second, one should search for investment advisers who have disclosed skills and a history of competitive investing.

I am currently in the process of helping a non-profit organization who has been hurt in this affair.

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