Madoff’s $50bn fraud points to urgent need for hedge fund reform

December 15th, 2008

It beggars belief that so many supposedly ‘sophisticated’ investors allowed themselves to be hoodwinked by Bernie Madoff, the former chairman of Nasdaq, who is likely to go down in history as one of the most successful fraudsters of all time.

Banks and professional investors including the Royal Bank of Scotland (£400m down), Santander (€2.33bn down), HSBC ($1bn “at risk”), Man Group (which lost £240m), Nicola Horlick’s Bramdean Asset Management (which lost £25m), are among the many victims of Madoff’s scam.

Other victims include France’s biggest bank BNP Paribas (€350m), Nomura Holdings, (£202m following its Lehman purchase) and the Swiss institutions Reichmuth ($325m), Benbassat & Cie ($935 million). EIM, a hedge fund group run by Arpad Busson, the multi-millionaire who is engaged to Uma Thurman, has lost $220 million.

Does this extraordinary saga simply prove the old adage that Wall Street’s principal role is to separate fools from their money (as some cynics have suggested)? Or are there wider lessons about the future of regulation and, specifically, the future of hedge funds industry?

The industry of which Madoff was a part is so opaque, I have a real fear there could easily be scores of other Madoffs lurking out there. Too many individual hedge fund managers have effective free rein to ply their trade without providing any disclosure of their methods – even to their own bosses and certainly not to auditors or regulators. This is clearly a highly dangerous state of affairs. Among other things, it has created carte blanche for unscrupulous but plausible crooks like Mr Madoff to rip gullible investors off.

Those investors who lost money through this scam might also want to take a good look in the mirror. In their quest for the holy grail of high returns, they appear to have been guilty of a quite extraordinary lack of oversight.

If they were at all suspicious of Madoff’s methods, the very least they could have done was to ask the most obvious of questions like “do I trust this guy” before committing other people’s billions. Their suspicions ought to have alerted them to the fact that, though his own brokerage arm, this guy cleared his own trades. To blame the regulators, as Nicola Horlick has done, represents a dereliction of duty. There’s a powerful article by John Kay in the Financial Times on her stubborn refusal to accept any blame, despite the 1.5% annual management fee charged by Bramdean, here: The titans’ inability to apologise for this sorry mess.

In the largest swindle in Wall Street history, Madoff styled himself a champion of transparency and integrity and duped countless institutional investors and a cosy coterie of Long Island socialites into handing over their cash.

The returns he promised were some 1% a month – and there were so consistent and reliable it ought to have set alarm bells ringing in investors’ heads (and it did in some). However, even when quizzed on the subject, Madoff was remarkably cryptic. Perhaps understandably, he never revealed how he was generating his spectacular returns.

The truth was Madoff was running a giant Ponzi scheme, otherwise known as a pyramid structure. While his older-established investment clients were being rewarded with abnormally high returns, the money to fund this was coming not from superlative investment skills but from the suckers joining in at the bottom. It was the “greater fool” school of investment.

Last week Madoff, aged 70, came clean, admitting to his two sons that his operations were “all just one big lie”, according to court documents. Madoff also told the employees he was “finished”, and that he had “absolutely nothing” left after investors sought to redeem some $7bn in early December. There is a now 24-hour guard outside Madoff’s office in midtown Manhattan.

Rick Di Mascio, chief executive and founder of Inalytics, a firm that specialises in evaluating fund management businesses on behalf of third party investors, said the fraud highlights the “fundamental lack of transparency” within the hedge fund industry.

“The willingness of the industry to accept this state of affairs, whether tacit or overt, can and must change,” Di Mascio told I&PE. “This is a major event and needs to shock everyone into action.”

He added the the situation stems from the lack of information and evidence which investors are provided with – but presumably also from their own failure to bother carrying out proper due diligence.

Di Mascio said it was ridiculous that some investors in hedge funds have to resort using employing private dicks to try and establish what is going inside funds in which they are considering investing. “This surely cannot be right,” he said.

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Posted by Ian Fraser on Dec 15 2008. Filed under Blog. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry