Showing posts with label Bernie Madoff. Show all posts
Showing posts with label Bernie Madoff. Show all posts

Monday, March 8, 2010

Barry Ritholtz on Madoff

As usual, Barry Ritholtz gets it right:

http://www.ritholtz.com/blog/2010/03/what-were-the-actual-losses-in-madoffs-fraud/

Love the example about the trillion dollars. Doesn't it seem that "trillion" will be 2010's word of the year?

Thursday, July 2, 2009

H.R. 2798: Madoff's Investors Ask for a Congressional Bailout

On seekingalpha.com's comments board, I've written that investors who invested directly with Madoff ought to get their original investment back from the SIPC, but nothing more. Feeder fund investors who invested indirectly with Madoff should look to their investment fund for recourse, not the SIPC or taxpayer. The SIPC fund was clearly not intended to reimburse mutual fund or feeder fund investors for bad investment decisions or advice. In any case, I assumed that only member banks and brokerages, not the taxpayer, fund the SIPC. I was wrong.

Most writers praised my earlier article, but a few detractors kept focusing on the SIPC coverage. I got curious about the SIPC and did a little bit of research. Guess what? At the end of the day, the SIPC is funded by American taxpayers. In fact, Congress is about to change the law, increasing the SIPC's borrowing limits and enabling the government to print money to give to the SIPC. No wonder the pro-Madoff-investor camp kept focusing on the SIPC--as long as the SIPC received taxpayer-backed funding, Madoff's direct investors would get paid. I naively thought that only private sector financial institutions were contributing to the SIPC fund. Again, I was wrong.

Some of what you will read below is technical. I did not spend more than half an hour researching the law, but I was able to ascertain a lot of information. It is shocking to me that the NY Times or some other major newspaper did not blow the cover off this scheme in early June 2009, when the House of Representatives drafted a special bill--H. R. 2798--for Madoff's investors.

Also, I cannot find anything online about what interest rate the Secretary of the Treasury is charging SIPC members. That number is key. If the interest rate is reasonably high, American taxpayers may eventually make money from SIPC loans; however, if the interest rate is low, then American taxpayers are basically giving Madoff's investors free money. In short, a low-interest-rate SIPC note is tantamount to American taxpayers acting as financial guarantors for Madoff's unconventional investment strategies and investors who voluntarily chose to invest in non-mainstream products.

First, let's cast aside the idea that most of Madoff's investors are going to be destitute. From the WSJ (Jay Miller, 07/02/09):

A total of $2.97 billion in claims has been allowed, including $2.74 billion that exceed the statutory limit of protection.

$231 million has been set aside for claims from victims of the Ponzi scheme, with another $2.74 billion authorized for potential recoveries.

Yes, Madoff's direct investors will divvy up almost $3 billion. If anyone starts talking about how Madoff's investors were poor widows, give them a three word response--three billion dollars--and a link to this article.

On top of the $3 billion, some of Madoff's investors--including the ones who invested through feeder funds--may come out ahead, courtesy of the American taxpayer. After the CPAs and tax lawyers are done exploiting new tax breaks, many Madoff investors will get credits for much more than their original investments. These changes may result in windfalls for Madoff investors. For example, let's assume you invested $5,000 with Madoff in 1975 (we're using smaller numbers for simplicity's sake). By 1995, your $5,000 investment has become $25,000. Then, from 1995 to 2008, your account balance increases to $50,000, which allows you to withdraw an average of $5,000 each year for thirteen years. Thus, even if you lose your entire investment in 2009, you've still gained much more than your original investment of $5,000. In addition, you will submit an SIPC claim for the full $50,000, even though your original investment was only $5,000.

Now, let's discuss the SIPC. The SIPC is basically a government-backed institution similar to the FDIC. Like Fannie Mae and Freddie Mac, the SIPC is not technically a government entity, but operates in a murky zone that's not quite "private entity" and not quite "government agency." (For the lawyers out there, the SIPC is codified in Title 15 USC Sections 78aaa. The SIPC fund is codified in Title 15 USC 78ddd.)

Below is a good summary of the SIPC, from SEC v. GUARANTY BOND AND SECURITIES CORP, 496 F.2d 145 (1974):

The Securities Investor Protection Act was enacted in response to the need to protect the customers of securities brokers and dealers which might fail, thereby jeopardizing the cash and securities that customers had left on deposit with the firm. S.I.P.A. accordingly created the Securities Investor Protection Corporation as a 'non-profit corporation,' not designed to 'be an agency or establishment of the United States Government,' but rather to be 'a membership corporation,' consistent with the self-regulatory nature of the securities industry. 15 U.S.C. 78ccc(a). The S.I.P.C.'s role is primarily one of consultation and cooperation with the self-regulatory organizations which remain subject to the federal securities laws and the rules of the S.E.C. By mandating membership in the S.I.P.C. for certain members of the securities industry and by granting the S.I.P.C. general assessment authority over the members in order to establish an S.I.P.C. fund, Congress accomplished its intention that the cost of providing protection to customers under S.I.P.C. was to be borne by the securities industry itself.

But look at footnote 3:

S.I.P.C.’s first responsibility under the Act was to establish a fund which would consist of all amounts received by S.I.P.C. and from which all expenditures would be paid. 15 U.S.C. Sec. 78ddd(c). If the fund should become insufficient for the purposes of the Act, the S.E.C. is authorized, if necessary for the protection of the customers of brokers and dealers and for the maintenance of confidence in the United States securities markets, to issue notes under certain conditions to the Secretary of the Treasury in an amount up to one billion dollars, which then may be lent to S.I.P.C. 15 U.S.C. 78ddd(g). [emphasis added]

Take a look at this bill, H. R. 2798, referred to the Committee on Financial Services in June 2009:

(b) Increasing SIPC line of credit with the Department of Treasury.—Section 4(h) of the Securities Investor Protection Act (15 U.S.C. 78ddd(h)) is amended by striking out “$1,000,000,000” and inserting “the lesser of $2,500,000,000 or the target amount of the SIPC Fund specified in the bylaws of SIPC”.

Congress wants to more than double the one billion dollars limit to make sure Madoff's investors will be paid in full. But that's not all. Congress also wants to increase the amount of money that the SIPC can directly pay Madoff's investors, from $250,000 to a whopping $850,000. See section (d) of the proposed bill:

(d) Eligibility for direct payment procedure.—Section 10(a)(4) of the Securities Investor Protection Act (15 U.S.C. 78fff–4(a)(4)) is amended by striking out “$250,000” and inserting “$850,000”.

Another section of the proposed bill increases the amount of cash payable to investors:

Standard maximum cash advance amount. For purposes of this Act, the term ‘standard maximum cash advance amount’ means [an increase from $100,000 to] $250,000, adjusted as provided under subsection (e) after March 31, 2010.

Don't let the March 31, 2010 date fool you--this proposed law will help investors prior to March 31, 2010, i.e. Madoff's investors. The language in subsection (e) refers to an "inflation adjustment" provision that gives the SIPC the discretion to increase the direct payment amount more than $250,000 after March 31, 2010.

It gets even better if you're a rich investor. There's practically no legal limit to the SIPC's power to increase the $250,000 cash advance amount. Two of the three factors allowing the SIPC to increase the amount are unconscionably vague. One talks about "economic conditions" and another refers to "potential problems affecting members of SIPC."

You'd think Congress would help non-rich Americans, who hold most of their money in bank accounts. The FDIC, not the SIPC, insures these bank accounts. Congress did pass similar insurance coverage for normal bank account deposits, but the coverage reverts to the old $100,000 limit in 2014. Here is a paragraph from the FDIC's website:

The standard insurance amount of $250,000 per depositor is in effect through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except IRAs and other certain retirement accounts, which will remain at $250,000 per depositor.

In contrast, the proposed SIPC changes have no sunset provision. Rich investors and Madoff's investors should thank House member Michael Arcuri, who represents New York's 24th congressional district, and House member Dan Maffei, who represents New York's 25th congressional district--these two men are the sponsors of HR 2798. They sure have their priorities right, don't they? After all, isn't it Congress's job to pay rich investors for their losses after they voluntarily invest their money with a reclusive financial advisor?

The best part? Although Arcuri's and Maffei's bill is basically a gift to Madoff's investors, it's called "Support Investment Protection for Customers Reform Act of 2009." The second best part? Both Arcuri and Maffei are Democrats. Next time you think there's much difference between Republicans and Democrats, or that Republicans are the party of the rich, just remember these words: "Support Investment Protection for Customers Reform Act of 2009."

Now, who is going to fund all this protection? Well, that’s where it gets confusing. A federal court's website states:

The fund is supported by assessments upon its members. If the fund should become inadequate, the SIPA authorizes borrowing against the U.S. Treasury. An analogy could be made to the role of the Federal Deposit Insurance Corporation in the banking industry.

Then look at 15 USC §78ddd(g) and (h):

In the event that the fund is or may reasonably appear to be insufficient for the purposes of this chapter, the Commission is authorized to make loans to SIPC...The Secretary of the Treasury may reduce the interest rate if he determines such reduction to be in the national interest.

See those words? Secretary of the Treasury? That means the U.S. Treasury, which manages government revenue--otherwise known as the taxes we pay. Have you figured it out yet? Yup, it’s the taxpayers who are going to pay off Madoff's direct investors, because the SIPC doesn't have enough money in the till to make the investors whole. The Treasury may just end up printing money--at a low interest rate--to save Madoff’s direct investors.

I really, really want to know what the interest rate is on these taxpayer-backed SIPC loans. (Where’s the NY Times when you need them?) What’s really funny/tragic is that the SIPC’s members include banks, which are already receiving billions of dollars of taxpayer money. Our government has printed money--to be paid by our children and their children--to give to banks, the SIPC, and Madoff’s investors. You might argue it’s not a giveaway, it’s a loan, but I’m not budging until I see the interest rate charged.

I can’t believe I didn’t see this before. I’m not a securities attorney, so I hadn’t looked at the specific code sections to see how SIPC was funded. (Where are all the articles from securities and tax lawyers? Perhaps they’re too busy figuring out how to make money for Madoff’s investors to do anything for the public interest.)

The way I see it, the American taxpayer has gotten screwed (again), and the rich seem to have a direct line to Congressional lawmakers. Rather than draft legislation that allows the orderly winding down of institutions when complex financial transactions cause multi-party failure, Congress is thinking about how to bail out Madoff's investors. No wonder China unofficially wants a modified reserve currency–our government keeps printing money without rhyme or reason. America’s financial credibility is eroding. Mark my words: unless fiscal discipline makes a comeback, this will end badly.

Update on July 10, 2009: Here is the letter I sent today to the House Financial Committee: http://financialservices.house.gov/contact.html

Dear House members:

I am asking that you vote against H.R. 2798 or decline to submit the bill for a full House vote. The proposed bill bails out Madoff's investors under the guise of shoring up the SIPC. In reality, SIPC members will only be expected to pay $1000 annually (up from $150 annually). This amount is stunningly low, given that credit unions have had to pay millions of dollars to shore up their own version of SIPC, the National Credit Union Share Insurance Fund (NCUSIF). Star One Credit Union, for example, will be assessed a $44.2 million charge to maintain adequate member protection. Thus, a revised annual SIPC fee of $1000 is laughable if consumer protection is the goal.

H.R. 2798 would be even more comedic if the money to expand SIPC protection wasn't coming from taxpayers. Unfortunately, because the SIPC has been woefully underfunded, if H.R. 2798 passes, the U.S. Treasury must issue loans to raise the SIPC fund's available credit from one billion dollars to 2.5 billion dollars. As you know, the U.S. Treasury is basically the American taxpayer, so ordinary Americans and their children will be on the hook for this proposed bailout.

Most tragically, H.R. 2798's proposed penalties for white collar crime are too low at five years' jail time and a $250K fine. Such minimal deterrence will not protect the public against a future Madoff. Approving such low penalties post-Madoff will make voters wonder if white collar criminals have lobbyists. I would not want my name associated with H.R. 2798 in its current form.

More on Bernard Madoff

From Reuters: http://news.yahoo.com/s/nm/20090702/bs_nm/us_madoff_sec

Walker-Lightfoot, a lawyer in the SEC's Office of Compliance Inspections and Examinations, sent emails to a supervisor saying information provided by Madoff during her review didn't add up and suggesting a set of questions to ask his firm, the report said. One of Walker-Lightfoot's supervisors on the case was Eric Swanson...Swanson later married Madoff's niece.

My earlier article on Madoff's investors generated numerous comments on Seeking Alpha's website. Here are some quick responses to the comments:

1. Someone wrote, "If you were one of those who lost a lifetime's savings, your article would have a slightly different sentiment." Perhaps you are right; however, I diversify my investments and I buy investments available to the public. I do not and cannot invest in hedge funds or other non-transparent "clubs."

2. Two people have criticized my grammar and spelling--please point out specific mistakes. One person wrote that "investors like you and I could not get Madoff" should have been written as "investors like you and me..." I disagree, but I will check my Strunk and White manual later.

3. An anonymous person implied that I would feel differently had Madoff's investors been of a different religion, more specifically Islam. That's the kind of irrelevant, divergent thinking that Madoff's investors want to avoid if they want any chance of sympathy. People are upset because of perfectly rational factors:

a) Madoff's investors should have diversified their investments;

b) Madoff's investors are receiving special treatment from the government in the form of special tax breaks (paid for by general taxpayers) and more-than-usual government resources;

c) Madoff's investors are seeking to portray themselves as poor widows when most of them are probably still more affluent than 95% of Americans (take a look at Madoff's client list, and you'll see many trusts, private banks, foundations, corporations, and LLCs);

d) most Madoff investors would not have invested heavily with Madoff unless they believed he had an unfair edge or special connections unavailable to the public investor;

e) Madoff's investors believed Madoff was using investment strategies unavailable to the general public (they were right--it just wasn't the strategy they expected);

People are also upset because they see a fundamental shift in values. In the old days, the rich believed they had a duty to the public. They recognized that capitalism necessarily results in winners and losers, and the government could not solve the problems of vast inequality and disparate opportunities by itself. Look at Theodore Roosevelt, John D. Rockefeller, Jr., and John Pierpont Morgan. It's hard to remember now that J.P. Morgan bailed out the federal government, but it really did happen.

I'm not saying all rich persons have lost their moral compasses. Eli Broad, Warren Buffett, Ted Turner, and Bill and Melinda Gates are doing wonderful things, but most of us work hard every single day and will probably never be worth millions of dollars, or even one million dollars.

Most of Madoff's investors got to the financial promised land and squandered their chance at permanent retirement. They did so voluntarily--no one forced them to violate basic investing rules and to invest heavily with Madoff. Thus, it is hard to stomach the general media's sympathetic coverage of Madoff's investors when so many Americans are homeless, out of work, and live paycheck to paycheck.

[The original post is here.]

Tuesday, June 30, 2009

To Madoff's Investors: Welcome to Main Street

[On July 1, 2009, seekingalpha.com chose this article as an "Editor's Pick." On July 2, 2009, it became the fourth most popular article on seekingalpha.com's website.]

The WSJ is issuing more Madoff victim propaganda. It is interesting to see the WSJ advocating free markets while slyly supporting special treatment for rich investors who failed to follow basic financial advice. Remember: Madoff's investors only lost their life savings if they chose to violate Investment 101's cardinal rule: diversify, diversify, diversify.

In a free market, the rich must suffer when they violate basic investing rules. Otherwise, you don' t have a free market. Instead, you end up with two separate systems--one where the rich get preferential rules and use Congress and the IRS as their own personal insurance policies, and another where everyone else has to suck it up when things fall apart.

As I wrote before here, people who invested with Madoff thought they were buying membership into an exclusive club shielded from the vagaries of the stock market. Middle-class investors like you and me could not get Madoff as our financial advisor. Most of us did not even hear about him until the scandal broke. We were barred from Madoff's circle because we weren't rich and we weren't connected with the elite. Meanwhile, Madoff's investors lobbied hard to gain entrance into Madoff's circle and did so because they believed returns were practically guaranteed. Well, it was an exclusive group, all right--a group of connected, rich suckers who thought they were getting a sweet deal unavailable to Main Street.

Perhaps you think me coldhearted. Don't be naive. If it wasn't for the stock market's monumental, once-in-a-lifetime bust, Madoff's investors would have continued making good, safe, and illegal returns year after year. Madoff's investors would have continued playing golf, donating millions of dollars to charities, and hanging out on their yachts while Madoff wormed his way higher in the NASD's upper ranks. In short, Madoff's investors would have been seen as pillars of their community because they knew Madoff. Meanwhile, the rest of us--not having access to hedge funds or Madoff's exclusive circle--would have had to make it on our own the old-fashioned way: by saving our pennies and diversifying our investments (otherwise known as Investing 101).

What's that? You say not all of Madoff's investors invested directly with Madoff? And not all of them were rich? Fine. Go after the mutual fund companies that failed to do due diligence and violated their fiduciary duties to their investors. Last time I checked, mutual fund advisors get paid millions of dollars in fees to do research on suitable investments, not to find secret investment clubs and then spend the week playing golf. Main Street investors rely on mutual fund managers to check investments and make sure everything's on the up and up. Many people--not just Harry Markopolos--knew something was wrong.

Remember: not everyone invested with Madoff. Many people questioned his too-consistent returns, noticed his small, little-known auditing firm, and went the other direction. By bailing out Madoff's investors, we're punishing smart, ethical people like Harry Markopolos and rewarding unethical rich people who begged to be a part of Madoff's club precisely because it used techniques unavailable to Main Street.

First, let's put all of this in perspective: according to the NY Times (6/29/09), $1.25 billion has already been recovered for Madoff's investors. The WSJ (6/30/2009, A1) cites a similar figure:

Mr. Madoff's attorney, Ira Sorkin, said that Mr. Madoff was a "deeply flawed individual" but maintained that most of the fraud money went to other investors. He added that the $13 billion figure cited by the government as the net losses suffered by account holders since 1995 was overstated, since at least $1 billion in recovered assets will be returned to investors, and perhaps a lot more.

In addition to the to $1 billion, the SIPC has already approved almost $200 million for Madoff's investors:

SIPC has mailed out about $142 million in checks to eligible claimants, out of a total of $188.4 million that already has been approved. [See WSJ (Jane Kim, 6/29/2009, C1)]

The above figures don't include the special tax breaks Congress pushed through for Madoff's investors. Oh, you didn't forget, did you? Congress changed the tax rules to benefit Madoff's investors. (Don't you wish we could do that?) If the test of fair capitalism is whether the rich have to suffer when they make mistakes, America is getting a "D" grade--and I'm being a generous grader.

On top of the tax breaks given to Madoff's investors because of their losses, millions of dollars of taxpayer money is being spent on what is essentially a civil fraud matter. Many middle class and poor Americans suffer fraud at the hands of scam artists. When was the last time you saw local D.A.s and the DOJ spending this much time and effort recovering money for middle-class and poor victims? Where are the tax breaks for small businesses going bankrupt because of the ripple effects from the big banks and hedge funds? I am disgusted by the attention given to investors who were either too lazy to follow basic investing rules or so sophisticated, they had access to special investment vehicles. I am also sorry the WSJ is ruining its credibility by portraying all of Madoff's investors as poor, impoverished souls who bear no responsibility for what has happened to them.

There are no shortcuts. Madoff's investors forgot about that. Now they want us to cover their hides because their exclusive club didn't pan out? Sorry, I don't do handouts to rich people or negligent investors--especially not investors who knowingly violate basic investing rules and look for shortcuts unavailable to Main Street. Non-rich people who invested with Madoff through mutual and feeder funds need to look to the banks and insurance companies for recourse, not the taxpayer. You have my sympathy, but don't push it. Get a job and start saving your pennies like the rest of us. And welcome to Main Street. It ain't so bad.

Sunday, December 28, 2008

More on Madoff

A consistent 15% return over 25+ years, without any losses, is impossible without some illegal advantage, such as inside information. Thus, Madoff's investors could not have reasonably believed they were receiving 10 to 15% every year without some insider information. In fact, Madoff's position as Nasdaq chairman probably convinced investors they had access to information no one else did. Click on the link for more.

Madoff's investors should have diversified or at least done more due diligence. Their failure to follow the well-known and cardinal rules of investing--diversify and buy only what you understand--is the sine qua non of their current situation.

Also, most of Madoff's investors were not unsophisticated investors--most were educated, English-speaking, and affluent. This is why Madoff slept soundly at night--in his mind, even if someone invested a million dollars with him, s/he most likely had plenty of money left over. Madoff may have even believed himself to be a modern-day Robin Hood--stealing from the rich to give to the poor and the charities.

At the end of the day, the blame belongs on Madoff and the fiduciaries of charities and other entities who failed to diversify donor and investor money. Rather than excuse negligence, Madoff's investors should serve as an example to those who fail to diversify or who do not question impossible returns. Bailing them out would result in the following:

1. It would tell the world America will print money and devalue the dollar when its citizens--especially the rich and well-connected--make avoidable mistakes. If the Japanese, Chinese, Swiss, and British begin to question the U.S. dollar's integrity, it will be the beginning of the end for our entire country. We have major deficits and are currently dependent on foreign investors to finance our expenditures. When we have a surplus, we can afford to be generous. Right now, we can afford to be sympathetic only with our hearts, not with our wallets.

2. It would weaken faith in our country's sense of fairness. Any time a government gives money away arbitrarily, others not part of the largess rightly cry foul. What about all the other victims of investment fraud, like the Baptist Foundation of Arizona or Sunrise Equities Inc.? What about the mortgage brokers who ripped off ordinary Americans by submitting mortgage applications with false income information? (By the way, where's the perp walk for those people?)

To those of you who say I have no sense of compassion or morality, let me say this: if anyone ought to receive taxpayer money, it should be the families of Americans who were slain in Iraq. They are also victims of government inaction and negligence and have lost more than just money. The list of more deserving victims is endless, but if we go down that path, we will transform America into a land of sympathy-seekers, not strength. For a country that has been the symbol of hope for so many people worldwide, such an image shift is unacceptable.

Although I opposed the auto and bank bailouts, they will help hundreds of thousands of ordinary Americans who had little power to avoid their current situation. Auto workers themselves did not cause their current financial mess--the banks, their unions and the Big Three did. In contrast, Madoff's investors failed to do due diligence, failed to diversify, and/or must have believed Madoff had inside information. As a result, they do not have clean hands.

Regulations resulting from the Madoff scandal, if any, should focus on requiring nonprofits and other charities to publicly disclose (preferably on a website) more than just basic financial information. Even in the absence of a law, donors should ask charities and nonprofits to disclose not only their P&L statements and budgets, but also where they are holding donations, and what specific investments they have bought. As long as taxpayer money is not involved, some good may come of this yet.

More on Madoff here:

1. "Capitalism without Failure is like Religion without Sin"

2. The one that started it all: Madoff the SIPC.

3. NY Times mentions Madoff (1/4/09).

Tuesday, December 23, 2008

"Capitalism without failure is like religion without sin."

On seekingalpha.com, my Madoff article has attracted the second most comments. I've added a comment of my own, which I share below:

I've read all of your comments with the hopes that our outrage will prevent another ill-advised bailout. Carnegie Mellon economist Allan Meltzer once said, "Capitalism without failure is like religion without sin." In other words, capitalism doesn't work unless we allow losers. Having losers creates two positive outcomes: one, it shows others what doesn't work (in this case, not diversifying or not doing due diligence when investing); and two, it creates shame--a powerful motivator--by warning others that bad actions lead to real consequences.

A Madoff bailout would be particularly harmful to capitalism as a whole, because it would pervert it into a tool for the rich and well-connected. I called the WSJ article propaganda because it focused not on the investors who made substantial returns over the 25+ years of investing with Madoff, but on charities and the elderly. Thus, it was deliberately designed to pull on our heart-strings for a class of people who are generally well-off.

The real victims are non-Madoff investors who will suffer diminished returns from their mutual funds. Their mutual funds hold companies like UBS and other entities that invested with Madoff. No one will be bailing out these Main Street investors, but they are the real victims. Yet, all the attention is being given to Madoff's investors, who are a highly exclusive group of hedge fund investors and investors who failed to diversify their investments.

In the end, a bailout is wrong because it would cause the transfer of wealth from people America should support rather than penalize. Basically, rather than reward people for making wise decisions or providing utility to others, a Madoff bailout ensures that Main Street will continue to suffer for bad decisions made by the rich and investors who failed to diversify.

If we wish to serve as a non-exploitative economic model for the rest of the world, we must allow some failure. We must not allow well-connected investors to make bad decisions and then escape the consequences because of their friends in Congress, on Wall Street, and in the Dow, Jones & Company publishing firm.

More important, if we want the U.S. dollar to continue being the world's reserve currency, then we must ensure the rich as well as the poor suffer the slings and arrows of bad decisions. The alternative is printing more money, which will lead to inflation, and reduced stature.

Mad about Madoff

My Madoff article became the most popular article on seekingalpha.com yesterday, as well as the third-most commented on article. People are angry. I hope their reaction pre-emptively stopped serious talk of another ill-advised bailout.

More comments and public reactions at the Daily Kos.

Sunday, December 21, 2008

Madoff and SIPC

When you click on the SIPC website, you will see a pop-up screen for "Madoff claims." I've been reading stories about the hard-luck investors and charities that invested with Madoff everywhere. In fact, Saturday's WSJ could almost be called propaganda designed to convince readers to feel sympathy for Madoff investors (thank God for the James Grant article, which salvaged the issue). Don't fall for it. Most of these investors knew what they were getting themselves into when they invested with a hedge fund. As for the people who invested through a "feeder fund," they should blame their well-connected managers and leave Main Street taxpayers alone.

First, only sophisticated individual investors can invest with hedge funds. A hedge fund is a private investment fund open to a limited range of investors. Such a fund is less regulated and allowed to undertake a wider range of activities than other investment funds. Basically, the rich have created a separate avenue of investment designed to make them even more rich--or, in some cases, less rich. Hedge funds come with unique risks--and individual investors knew that going in. That's partly why few of Madoff's investors asked questions--a hedge fund is designed to be less regulated, so there's more allowances made for secrecy. Madoff operated as a hedge fund until 2006, when the SEC finally forced him to operate solely as a broker-dealer.

Second, you should always be wary when the government or the media says Wall Street should have more protection or attention than Main Street. Investors like you and me are limited to KKR Financial (KFN) or Blackstone (BX) if we want a piece of the hedge fund mystique. How are those stocks doing? Well, KFN is around 57 cents per share. BX is about $6/share, with a 52 week high of $23.87/share. In short, Main Street investors didn't do much better than Madoff's investors--and the SIPC isn't going to help us. Why should Madoff's investors--who already had access to a special fund--get special help or special sympathy? I don't see sob stories featuring Blackstone or KKR investors.

I am deeply concerned that taxpayer monies may be used to reimburse Bernie's rich investors more than the usual $500,000 SIPC coverage. Bernie's investors should receive half a million dollars each. I fear that Congress will increase or finance SIPC insurance, purportedly as a populist move (I can already hear the words, "For our protection")--and then make the increased limits retroactive. If that happens, taxpayers will be paying more bailout money, this time to sophisticated, rich investors.

Don't be scammed. Most Madoff investors were doing fine before Madoff, and they are still better off than 99% of the American population today. If they convince you otherwise, perhaps they really do deserve to be called sophisticated investors--after all, if Madoff's rich investors are smart enough to get reimbursed for 100% of their losses when they knowingly invested in a less regulated fund, the American taxpayer is indeed unsophisticated.

Update: Kathleen Pender of the SF Chronicle had a very comprehensive article about Madoff in the Chronicle's December 21, 2008 issue (page C1).

Update: Madoff's investors are already asking for a taxpayer bailout:

"There's no doubt that hearings will be held on this, and some government aid is a very logical request," said Robert Schachter, an attorney with New York-based Zwerling, Schachter & Zwerling, which is representing several Madoff victims. "If we're bailing out Wall Street and the auto industry, maybe these individuals should be bailed out too."

[Additional cite, Joe Bel Bruno, AP Business Writer]

More on Madoff here:

1. "Capitalism without Failure is like Religion without Sin"

2. Clark Winter on hedge funds, in The Either/Or Investor, page 88: (although the book was pre-Madoff scandal, it still has relevance to Madoff):

Hedge funds are basically nondirectional investments designed to take advantage of the indecision of markets. Once upon a time, you needed to be a millionaire in order to be qualified to invest in hedge funds--they are loosely regulated, and it is possible for investors to lose all of their money quickly if a manager's strategy goes awry...so only wealthy investors are allowed to use hedge funds as investment vehicles. But increasingly, institutional investors such as universities and mutual funds have placed a portion of their money with hedge fund managers, to their customers' benefit.

[on page 105] Wall Street's performance demands had gotten so out of line that some corporate chieftains could only make their numbers by faking them.

Update: It was only a matter of time--Madoff's investors have asked the 111th Congress for a bailout. The House of Representatives has obliged, and the House Committee on Financial Services is currently reviewing H.R. 2798. As of July 10, 2009, H.R. 2798 has not been submitted for a vote. You may write to the House Financial Committee using the following link: http://financialservices.house.gov/contact.html

Here is my letter, which you are welcome to copy:

Dear House members:

I am asking that you vote against H.R. 2798 or decline to submit the bill for a full House vote. The proposed bill seeks to bail out Madoff's investors under the guise of shoring up the SIPC. For example, SIPC members will only be expected to pay $1000 annually (up from $150 annually) into the SIPC fund. This amount is stunningly low, given that credit unions have had to pay millions of dollars to shore up their own version of SIPC, called the National Credit Union Share Insurance Fund (NCUSIF). Star One Credit Union, for example, will be assessed a $44.2 million charge to maintain adequate member protection. Thus, a revised annual SIPC fee of $1000 is laughable if consumer protection is the goal.

H.R. 2798 would be even more comedic if the money to expand SIPC protection wasn't coming from taxpayers. Unfortunately, because the SIPC has been woefully underfunded, if Congress passes H.R. 2798, the U.S. Treasury must issue loans to raise the SIPC fund's available credit from one billion dollars to $2.5 billion. As you know, the U.S. Treasury is basically the American taxpayer, so ordinary Americans and their children will be on the hook for this proposed bailout.

Most tragically, H.R. 2798's proposed penalties for white collar crime are too low at five years' jail time and a $250K fine. Such minimal deterrence will not protect the public against a future Madoff. Approving such low penalties post-Madoff may cause voters to wonder if white collar criminals have lobbyists. I would not want my name associated with H.R. 2798 in its current form.

Sincerely,
Name

Update: Click here for more on Madoff's investors.  It's titled, "To Madoff's Investors: Welcome to Main Street."