The Madoff affair
Adapted slightly from the original article
Dumb money and dull diligence
Dec 18th 2008
From The Economist print edition
Like mould, Madoffs flourish in the darkness
WRITING about one of the great swindles of the 1930s, J.K. Galbraith pointed to three traits
of any financial community that he believed put it at risk of fraud. There was the tendency,
he wrote in 1961, to confuse good manners and good clothing with trustworthiness and
intelligence. There was the sometimes “disastrous interdependence” between the honest
man and the criminal. And there was the “dangerous cliché that in the financial world
everything depends on confidence. One could better argue the importance of continuous
suspicion.”
The case of Bernard Madoff, a New York financier who has allegedly confessed to running a
ponzi scheme that destroyed up to $50 billion of his clients’ money, has all three. The
former chairman of NASDAQ stock exchange was as well known to insiders on Wall Street
as he was in the fancy Florida country club, where he was a pillar of Jewish philanthropy.
His clients were fiercely loyal; they had to be or he would cut them out of his sacred
investment circle and repeated monthly returns of metronomic regularity. And he flourished
in an era of cheap credit, when greed and trustfulness became far more powerful than fear
and suspicion.
What marks Mr Madoff’s case, however, is the level of investor he sucked in and tricked. It
is not the first time that wealthy people have been cheated out of huge sums of money, nor
will it be the last. But never before have so many big financial institutions been so cheated
by an individual. It is here that investors, as well as the authorities, should tighten the
screws and demand more transparency.
Oxymorons
Tragicomically, a handful of global banks that had fared well during the financial meltdown
of the past 18 months are on the list of those caught out. HSBC, a British bank, Santander
of Spain, and BNP Paribas of France: all bear a share of losses that add up to $33 billion,
according to a Bloomberg report.
It is, however, the reputation of the big funds of hedge funds—some belonging to the
banks, others at firms like Britain’s Man Group and America’s Tremont Capital
Management—that have been most damaged. They charge whopping fees, say 1.5% of
assets, largely on the basis of their ability to pick out clever people to manage their clients’
money. Their business has flourished partly because the hedge-fund industry is so nontransparent:
if investors could dig out more information for themselves, they would not
have to pay others to penetrate the veil for them. They are also the largest investors in
hedge funds, accounting for about half the investment in the industry, or $800 billion at the
end of last year.
Yet for all their insights and access, some of them missed red flags flying over Mr Madoff’s
business, such as the way he kept custody over his clients’ accounts, handled the trades
himself and employed an rather unknown accounting firm. They ignored warnings from
lesser mortals, such as one in 2001 from MAR/Hedge, a diligent trade journal. They never
wondered why, though the sums he managed were vast, he rarely caused even a small
wave in the markets. Their argument that enlightened self-interest is a reason to leave the
hedge-fund industry largely uninvestigated and unregulated looks ever harder to sustain.
The investors were not the only idiots. The regulators, too, were taken for a ride. The
Securities and Exchange Commission (SEC), Wall Street’s regulator in chief, overlooked Mr
Madoff’s investment-advisory business, even though it had assets under management of
$17.1 billion at the start of 2008. The outgoing head of the SEC has admitted the
commission made a mess of the Madoff case, failing to act on warnings made nearly a
decade ago.
Not even the best of regulators (and the SEC is not that) can be sure of stopping a
determined fraudster. The authorities can, however, help investors make better judgments
by requiring more disclosure from hedge funds and other high-fee asset managers. It would
have been particularly useful to know how much of their clients’ money they were investing
in inscrutable people and illiquid assets—even if, at the time, few investors may have cared.
The industry has made a fetish of keeping its clients—and competitors—in the dark about its
holdings. But the credit crunch has revealed how few original ideas most of them held. Like
sheep, many of them flocked to borrow money to enhance returns, and, in return, the
investors thought they were geniuses. Some also turned to money managers like Mr Madoff,
where they were mercilessly fleeced.
Let the light shine in.
Essay Prompt
In “Dumb Money and Dull Diligence”, The Economist argues that the Madoff
case provides evidence that more transparency is needed in investment
firms. In your opinion, is it is the responsibility of the government to
regulate these firms to ensure transparency, or the responsibility of the
individual investor to do his own research (“due diligence”) before investing
his money? Write an essay in which you argue your point. Your analysis
should be based primarily on the article and should include direct references
to the article. However, you may also use outside examples or other
evidence to support your point.
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PinkZeppelin65გადამაწერინებ?
ISET, 2 year Master Program in Economics
