Only In Bad Times Do We Know Who Is Swimming Naked

Financial course fees for investors are getting ridiculously expensive. In the Lehman Brothers debacle, some investors parted with their life savings to learn complex financial terms, like collaterized debt obligations, derivatives, credit default swaps, first to default, credit linked notes, etc.

Next lesson up is about ponzi scam – where early investors are paid outsized returns from the commitments of new investors. Bernard Madoff, former NASDAQ chairman ran a $50 billion fund where annual returns of over 10% were paid to his clients in a ten-year period.

Those in the fund management industry should know that consistently beating the market is nothing short of miraculous. Investors were either in the hands of a genius or a fraudster. As it turns out, the financial tsunami which decimated Wall Street called time on Madoff’s scheme.

New clients began to dry up while Madoff was forced to pay massive redemptions when clients withdraw their cash. He finally confessed to prosecutors that he “paid investors with money that wasn’t there” and there was “no innocent explanation” for his behavior. “It’s all just one big lie” and that it was “basically, a giant Ponzi scheme.”

Well done, I give Madoff credit for having the spine to own up to his crime instead of feigning ignorance, blaming extraneous circumstances, shifting responsibility to regulators or investors who failed to conduct their due diligence. However, being a long-standing leader (since 1960) in the financial services industry, his indictment is scant consolation for heartbroken investors staring at worthless pieces of paper.

Trust in the entire $1.6 trillion hedge fund industry is now destroyed. Investors threw their lot behind hedge funds because, as the name implies, the fund mangers hedge their risks prudently and are sophisticated in their selections. Hedge funds that invest in other hedge funds, also known as “fund of funds” are considered even safer due to diversification of risks.

They won investors over with portfolio diversification and meticulous due diligence into other funds’ management and investment strategies. Their fees are not cheap, usually 2 percent, and they get a cut of the profits that can reach 20 percent, easily earning them billions of dollars in profit per year.

It now seems that their “stringent” selection process consist of mainly investing money in Madoff’s funds and earning a spread from the returns. If that is the case, any one of us could have started a hedge fund on our own, study which funds have performed well, and then start conning, err, earnings fees from investors.

Madoff’s scam begs a pertinent question. Where were the regulators all this while? Granted that Madoff was clever at concealing his track. His stockbroking firm was run on a separate floor from his cryptic investment business and he kept his business transactions under lock and key. Clients were deprived of online access to their accounts and they were led to believe Madoff invested in blue-chip stocks and options.

Still, there were sufficient red flags for the Securities Exchange Commission (SEC) to launch investigations. Madoff’s outside auditor was only a three-man show that wasn’t nationally recognized. He also didn’t have a third-party administrator signing off on his books, but did the clearing, settling and accounting in-house. More importantly, Madoff’s Ponzi scheme was exposed in a detailed complaint to the SEC in 1999 and 2005 but little action was taken.

Let us be clear that what Madoff did isn’t new. His predecessor, Charles Ponzi did such a fine job of “robbing Peter to pay Paul” in the 1920s that the devious scheme was named after him. Ponzi offered spectacular returns – 50 percent on money invested for 45 days, to investors who bought into his complex postage operation.

Who Is Swimming Naked

He was actually using new money to pay off interest on the old money. As long as deposits grow fast enough, the scheme survived. Eventually, suspicious public authorities forced him to stop taking deposits and the scheme imploded.

That 1920s financial orgy was a percursor to the Great Depression because liquidity flowed with abandon and people cultivated a free-lunch and get-rich-quick mentality. Normally intelligent, rational people ended up being tricked by the power of Ponzi schemes.

Yet, despite techonological breakthroughs, better education, and a painful lesson from the Great Depression, we see that human behavior rarely changes. None of us learned that the free market run by capitalists is a monster that needs independent and tough regulation to save itself.

I have nothing against the capitalist system. It is good - people are incentivized to work hard and reap their rewards. It is certainly not fair if you toil all day and receive as much as your neighbor who has been idling away. However, when Wall Street take it to extremes as in their mantra, “What is worth doing is worth overdoing,” then somebody has to step in and prevent the lemmings from committing mass suicide.

As in the case of Enron which wiped out $60 billion of shareholder value, corporate scandals come to light in every economic crisis. Warren Buffet once commented, “when the tide goes out, we know who has been swimming naked.” Indeed, when the economy is doing well, people are trusting and less vigilant, which breeds rampant larcenous activities, like embezzlement and Ponzi schemes.

The words of JK Galbraith in his classic “The Great Crash: 1929″‘ still ring true today, especially the part about bezzle. During embezzlement, there is a period when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. This inventory of undiscovered embezzlement – bezzle for short – results in a net increase in illusionary wealth and everybody feels rich. But when reality hits, as it will eventually, the result is disastrous.

Even if there is no Ponzi scam or embezzlement, investors have to deal with corporate managements who indulge in dishonest practices. For example, accelerating recognition of future earnings to show higher income, hiding indebtedness in subsidiaries, and dubious judgment of off-balance sheet items.

To conceal its deceit, it is common to find the business trying to grows its way out of trouble through acquisitions. Valuation of the business is difficult when multiple acquisitions happen. Recently, there was strong pressure from Wall Street to adopt mark-to-market accounting. That is absolute rubbish and will only allow their mismanagement, corruption and irresponsible accumulation of toxic assets to continue.

Financial engineering is often fueled by an obsession to reach certain operating targets so that the executives can receive excessive compensation. Whether it is beneficial for the company in the long run is immaterial. I am sure there will be more naked swimmers as the the tide goes out in this deep recession. Bernard Madoff is an exceptional case but he is only the tip of the iceberg.

What is an investor to do when so much dishonesty abounds?

Frankly speaking, if a management collude with auditors, rating agencies and regulators, there is very little protection for investors. It is sad that a brilliant management should use their creative energy to game the system instead of focusing on their core business and building deep competitive moats.

The only advice I can give is that we invest with money we can afford to lose and to make our own investment mistakes. You can’t do worse than the fund managers as they have been statistically beaten by a dart-throwing monkey.

The nearer we are to retirement age, then the more we should avoid any, and I say once again, ANY investment product. Just put it into a fixed deposit and get a steady return every year.

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More on this topic (What's this?)
Some Investors Predicted the Madoff Debacle
Bernard Madoff Fraud | Auditings & Due Diligence
Lawfirm Examines Hedge Fund Misrepresentation for Investors Benefit
Read more on Bernard Madoff at Wikinvest

3 Comments

Filed under Hedge Funds, Stocks

3 Responses to Only In Bad Times Do We Know Who Is Swimming Naked

  1. Hi Jeflin

    Here’s wishing you a Merry Christmas and a Happy New Year!

    Be well and prosper. :-)

    Panzer

    Panzers last blog post..Merry Christmas to all Five Cents Ten Cents Readers!

  2. Pingback: Only In Bad Times Do We Know We Is Swimming Naked | TheFinance.sg

  3. Happy New year!! Wishing you all the best in 2009. Good life & Good health. More blessings to all of us. Cheers!

    PinayKeyPoints last blog post..Mount Pinatubo Trek

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