Over the hedge?

By Matt Buttell, Deputy Editor

Following last December’s arrest of Bernie Madoff and the discovery of history’s largest Ponzi scheme, FST looks at how its repercussions are likely to play a role in putting back together the industry’s already changing landscape.

“What Madoff has done is highlight the lack of regulation. There’s going to be a shake out. Even before Madoff, the hedge fund industry was seeing redemptions and wasn’t producing absolute returns”
-Claude Le Ber, CEO of Banque Safdie SA

It was in 1960, at the age of just 22, that Bernie Madoff began his financial career by taking the $5000 he had saved from summer jobs as a lifeguard and a sprinkler system installer and setting up the investment firm Bernard L Madoff Investment Securities LLC.

The beginning of his story reads like the perfect urban fairytale: a man realizing that he has a talent for making money and applying it in a realistic and sensible fashion. Over time, Madoff went on to chair the NASDAQ stock exchange, as well as continuing his responsibilities as the chair of his own firm, gaining a trustworthy reputation among industry insiders and investors alike.

Then, on the 11 December 2008, Madoff was charged with perpetrating the largest investor fraud ever committed by a single individual and his urban fairytale exploding into global news.

Madoff's assets and those of the firm were frozen and according to federal charges Madoff himself admitted that his firm has “liabilities of approximately $50 billion”. Since the case has come to light many banks, including several from outside the US, have reported that they have potentially lost billions in US dollars as a result of fraudulent activities.

Many investors, journalists and economists are already questioning Madoff's statement that he alone is responsible for the large-scale operation, and investigators are looking to determine if there were others involved in the scheme. As the investigation continues, much of this remains unanswered.

One thing, however, is obvious: the mess couldn’t have come at a worse time. And during a period when stock markets are falling, it does beg the question of why so many wealthy and sophisticated savers were conned into believing that Madoff had come up with an investment strategy that allowed him to pay such handsome returns? After all, if something in this world sounds too good to be true that’s usually because it is too good to be true. One unnamed senior regulator, who has been involved in formulating public policy for many years, was quoted in the New York Times as saying the reason these people were conned is depressingly simple: “People are prone to believe what they want to believe,” he said, “and in rising markets a kind of irrational euphoria takes hold in which we are not inclined to ask ourselves difficult questions.”

Scrutiny
The massive bailout of the American financial system in October last year worryingly introduced the concept that our banks are ‘too big to fail.’ In other words, banks are of such importance to the world's financial system that governments would rather prop them up with public money than allow them to suffer the consequences of their own greed or incompetence and – in his own way – Madoff is the same as these banks: an investment advisor too respectable to scrutinize.

And now, as if the housing crisis, liquidity freeze, deepening recession and a prospect of deflation weren’t enough for the world’s financial system to deal with, we also have the Madoff affair pulling at the strings of our economy.

Hedge funds for example have been in a downward spiral for months, as, in response to the worrying economy, investors have been pulling money out fast. Even supposedly untouchable portfolios such as those at Citadel Investment Group have lost half their value over the past 12 months. Nonetheless, Wall Street had remained optimistic that investors would stick by hedge funds if the markets stabilized, thereby buoying the industry’s fortunes. But as the list of victims affected by the Madoff scandal continues to grow, hopes for the future of hedge funds looks increasingly bleak. Reports now indicate that investor confidence has now sunk to an all-time low, and it could take years for managers to regain the trust they once had. Economists have gone on to predict that the industry that emerges from the other side of this crisis will most likely be considerably smaller, humbler and cheaper than the one that began 2008, with near $2 trillion in assets. And Claude Le Ber, CEO of Geneva-based Banque Safdie SA, who three years ago withdrew money invested with Madoff, has said that the scandal will likely mean considerably more hedge fund regulation.

“What Madoff has done is highlight the lack of regulation,” Le Ber said during a recent press conference in Geneva. “There’s going to be a shake out. Even before Madoff, the hedge fund industry was seeing redemptions and wasn’t producing absolute returns.” Safdie, with $5.9 billion under management at the end of 2007, is the second Swiss bank after Credit Suisse Group AG to disclose withdrawals of money before Madoff confessed to swindling investors.

 “A lot of Swiss private banks were hurt,” Le Ber continued. “He was able to cultivate a circuit and put people in a position where they felt that opening an account was doing them a favor.” Le Ber added that Bank Safdie withdrew money that it had placed with Madoff back in October 2005 because it wasn’t getting enough information about the investment.

Global ramifications
On December 15, three days after Madoff’s arrest, a number of Europe’s largest financial companies revealed their exposure – most notably Spain’s Banco Santander, Iberian rival Banco Bilbao Vizcaya Argentaria and France's BNP Paribas, who all confirmed losses to address the growing concerns of their investors. Later, troubled Benelux bank Fortis said that its Dutch subsidiary had indirect exposure of somewhere between $1.17 billion and $1.38 billion to Madoff's investments, while French insurance giant Axa also revealed potential losses in the range of $136 million.

What’s more, even those who pulled out of Madoff’s funds before the blow-up even happened could be forced to return their proceeds and principal. Just a few months before Madoff’s arrest, the Fort Worth Employees’ Retirement Fund pulled $10 million out of a hedge fund that invested exclusively with Madoff. But now the managers face the possibility of having to give back the money – a sum that includes all of the pension's purported gains over the years, plus its initial investment.

The consequences of the Madoff scandal seem to be running far and wide. At the beginning of January, at the first hearing of the Financial Services Committee on the alleged fraud, both Republican and Democratic House members said the debacle surrounding Madoff reflected deep, systemic problems of the US Securities and Exchange Commission.

“Clearly our regulatory system has failed miserably and we must now rebuild it,” said Representative Paul Kanjorski, a Democrat who chaired the hearing, adding that the scandal "fell through the cracks” of the regulatory system. "It now appears that regulators should have detected the Madoff wrongdoing earlier because of the red flags raised by others."

With a continuing investigation, it is hard to make any solid predictions regarding how the Madoff scandal will really impact our economy. However, already it is clear that the ramifications will be felt for years to come. Most notably in relation to the future of hedge funds, where without the huge source of ready money, both from funds of funds and bank credit lines, hedge fund returns will suffer even after the markets eventually bounce bank.

Close-up: What is a Ponzi scheme?

A Ponzi scheme is a fraudulent investment operation that pays returns to investors out of the money paid in by subsequent investors rather than profit.

The Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going.

The system is destined to collapse because the earnings, if any, are less than the payments.

The scheme is named after Charles Ponzi, who became notorious for using the technique after emigrating from Italy to the United States in 1903. Though Ponzi did not invent the scheme, his operation took in so much money that it was the first to become known throughout the US. It was, in theory, based on arbitraging international reply coupons for postage stamps, but soon diverted investors' money to support payments to earlier investors and Ponzi's personal wealth.

Victims of Madoff

In the case of Bernie Madoff, there have been some notably high-profile victims. Here, FST takes a look at some of the most prolific.

• Director Steven Spielberg's charity, Wunderkinder Foundation, ‘appears to have invested a significant portion of its assets with Madoff, based on regulatory filings,’ according to the Wall Street Journal.
• Real estate and publishing magnate Mort Zuckerman had a large amount tied up in a fund that invested heavily in Madoff's firm.
• Nobel laureate Elie Wiesel's charity organization, Foundation For Humanity, reportedly had $10 million tied up in Madoff's organization.
• Lawyers for Sen. Frank Lautenberg said they weren’t sure how much the senator’s charitable organization has lost but said ‘the bulk of its investments had been handled by Madoff.’
• Spain's Santander banking group, which operates in Europe and Latin America, was another big loser with exposure of $3.07 billion to Madoff's scheme.

16 years of investigation

For over a decade and a half, regulators from the SEC and other agencies conducted numerous examinations at Madoff’s offices, but failed to uncover fraud.

1992 NY SEC sues four individuals for illegally raising $440 million in what was thought to be a massive Ponzi scheme apparently unrelated to Madoff. The money, however, is managed by Madoff, and is both intact and redistributed back to investors.

1999 SEC in Washington DC opens limited examinations into Madoff and two other firms to review trading practices. SEC finds violations in trade executions and Madoff says he will address them.

2004 SEC in Washington DC open a limited exam looking into whether Madoff is front-running his market-making trades to benefit hedge fund clients. SEC finds no violations and refers the case to its New York office.

2005 NY SEC opens a limited examination looking into suspicious emails found during the review of a hedge fund as well as news stories that raised questions about Madoff’s consistent returns. The SEC issues a delinquency letter citing execution and trading violations.

Nov. 2005 SEC investigators in New York meet with Harry Markopolos, a former executive of Madoff’s who, in a 21-page presentation, suggests Madoff is running the world’s largest Ponzi scheme

2006 SEC NT staff opens an enforcement investigation. The SEC finds that Madoff and one of his clients misled the agency about investors in the past about its money-management business. Madoff agrees to register as an adviser and the SEC closes the investigation 22 months later.