Okay, maybe you’re sick of this, but revelations keep coming out that beg still more questions. It seems Madoff had not traded in at least 13 years. What I want to know is, what were the supposedly innocent folks on the broker/dealer side of his business making of this? They were the listed custodians of Madoff’s investment funds. Did they not wonder why there were no trades coming through, or why the amount of cash in the account seemed light? Or perhaps they saw nothing at all and just assumed Madoff was custodizing his $50 billion fund elsewhere. If that’s the case, didn’t they ask Madoff why they were the ones listed as custodians? My point is, someone on that side of the business must have pieced this together at some point.
Also, I have a new operating theory as to what the feeder funds knew and didn’t know. As you know, I’ve thought it unlikely that they had any direct knowledge of fraud. None of them seem the co-conspirator type, frankly. That’s still my view, but the key word is “direct.” Over the years, it is inconceivable that Fairfield Greenwich and others weren’t aware of the constant whispering about Madoff. But much of the whispering didn’t center around Madoff as a Ponzi, but rather Madoff as a front-runner. It was widely assumed that Madoff was using his brokerage to front-run client trades and then using these profits to bolster the returns of his “hedge fund.” If this was in fact the case, the returns might have been real, if illegally obtained. So the feeders figured that the worst case scenario was the Feds would come in one day and shut the operation down. Madoff would get in trouble, but they wouldn’t, and they would likely keep all their returns.
I believe this because it fits the facts. It would explain why there was no real due diligence, for one. The feeders adopted a “don’t ask, don’t tell” policy, less the party come to an abrupt end. It also explains why Fairfield had three auditors in three years. They were clearly looking for an auditor with the same elevated level of incuriosity as they.
Friday, February 27, 2009
Thursday, February 26, 2009
Creating the Perfect Ponzi
The latest revelation, as you know by now, is that the Stanford Group (beware of venerable name use!) is another Ponzi, this one a mere $8 billion. Obviously, Sir Allen Stanford didn’t figure out the whole feeder thing. Other scams have come to light as well.
All this has had me pondering if it’s possible to get away with a Ponzi scheme. By “get away with,” I mean stand a high probability of dying before being caught. Some argue that Bernie Madoff, because he lived in great luxury for decades, got away with it, but no, that’s not good enough for me. I don’t want to go to the big house, and I’d just as soon be gone from this earth by the time my name became synonymous with evil. So think of this as a mental exercise like how to commit the perfect murder or pull off a big jewel heist. I merely want to know if it can be done. (Hopefully, the SEC is engaging in this same mental exercise as we speak.)
The answer, I think, is yes. The rules are as follows:
1. Never invest or risk the money in any way. Put it all in cash.
2. Don’t be completely crazy-greedy.
3. Don’t claim ridiculous returns.
It all comes down to managing the gap between the assets you claim to have, and the assets you really have. I played with the variables and came up with some parameters that I think work:
1. Claim 10% returns per year.
2. Raise 10% (or more) net new assets from investors per year.
3. Invest all assets in cash.
4. Keep the cash returns for yourself (that would be the illegal part).
On the following page we examine how this scheme would have played out over the last 25 years. I assume a $10 million initial funding.
Sorry, a little hard to read. The “fees” column represents what was earned in cash every year (at actual historical rates) and also what our would-be Ponzster is skimming from the fund. Note that the total theft works out to $182 million. Not Madoffian, but it beats working at a 7-11, or even as a trading grunt for Stevie Cohen.
The key numbers are in the right hand column. This represents the percentage of your actual assets that would have to be redeemed before you ran out of cash. This is the number you have to manage carefully. Note in this scenario it levels off at close to 50%. This means that you could have half your investors redeem and you could still keep the scam going. What are the odds of this? I’d say quite long, since you’ve been posting such reliable returns all these years.
But Madoff posted reliable returns also, you say! Without a doubt, Madoff came closer than any before, (that we know of) to pulling off the perfect Ponzi. I’m reasonably sure, though, that early on he violated Rule 1 – put the money in cash - and possibly rule 2 - don’t be crazy-greedy. While all the details aren’t in, I think it’s likely that Madoff blew some money in the market at some point, maybe in the late 80s or early 90s, and this was probably his undoing. He did run a large broker/dealer, after all, and no doubt thought he knew a thing or two about making money. As for the greedy part, that’s a more interesting question. I mean, of course he was greedy, but it may be that the amount he spent on himself, despite the yachts and villas, was not over-the-top relative to the amount of money his firm was allegedly making. His far-flung homes were – relatively – modest and his apartment in New York is on Lexington Avenue, not an address associated with moguls. I actually think he was more motivated by prestige than money, but I’ll leave that call to others. Let’s just agree to call him a disgusting pig.
What’s relevant was how well he had managed his funding gap. From the available information, he managed it better than anyone else ever has, who’s been caught, anyway. His key insight was his understanding of Rule 1: don’t claim ridiculous returns. Most Ponzsters aren’t particularly bright, or lack patience, so they claim to make 50% every 90 days, or whatever. Most Ponzsters, in fact, break all three of our rules. Madoff, merely by grasping Rule 1, was able to perpetuate his scam for decades.
An interesting question is, what was Madoff’s actual funding gap? From anecdotal evidence surrounding redemption requests prior to the scam being revealed, I’m betting it was close to 75% or 80%. That’s clearly in the danger zone.
Now here's how to get out of the whole thing before you get caught: simply have a terrible year. 2007 was a very troublesome year for many hedge funds. Madoff could have seized the opportunity to say, oops, my models failed me. Sorry, but I lost 75%. I strongly suspect he would have gotten away with this.
So there you have it, a road map. I was going to say you might want to come up with a plausible investment strategy to go along with it, but that doesn’t seem to matter much to gullible investors.
(Note: one key assumption I have made is that the bogus fund raises 10% of new capital each year. Clearly, this number would vary (and occasionally be negative), but I think it’s reasonable, perhaps conservative, given the claimed returns. Also, for simplicity’s sake, I have assumed straight-line 10% returns. The smarter thing to do, post-Madoff, would be to have some variability, but not so much as to scare investors away.)
All this has had me pondering if it’s possible to get away with a Ponzi scheme. By “get away with,” I mean stand a high probability of dying before being caught. Some argue that Bernie Madoff, because he lived in great luxury for decades, got away with it, but no, that’s not good enough for me. I don’t want to go to the big house, and I’d just as soon be gone from this earth by the time my name became synonymous with evil. So think of this as a mental exercise like how to commit the perfect murder or pull off a big jewel heist. I merely want to know if it can be done. (Hopefully, the SEC is engaging in this same mental exercise as we speak.)
The answer, I think, is yes. The rules are as follows:
1. Never invest or risk the money in any way. Put it all in cash.
2. Don’t be completely crazy-greedy.
3. Don’t claim ridiculous returns.
It all comes down to managing the gap between the assets you claim to have, and the assets you really have. I played with the variables and came up with some parameters that I think work:
1. Claim 10% returns per year.
2. Raise 10% (or more) net new assets from investors per year.
3. Invest all assets in cash.
4. Keep the cash returns for yourself (that would be the illegal part).
On the following page we examine how this scheme would have played out over the last 25 years. I assume a $10 million initial funding.
Sorry, a little hard to read. The “fees” column represents what was earned in cash every year (at actual historical rates) and also what our would-be Ponzster is skimming from the fund. Note that the total theft works out to $182 million. Not Madoffian, but it beats working at a 7-11, or even as a trading grunt for Stevie Cohen.The key numbers are in the right hand column. This represents the percentage of your actual assets that would have to be redeemed before you ran out of cash. This is the number you have to manage carefully. Note in this scenario it levels off at close to 50%. This means that you could have half your investors redeem and you could still keep the scam going. What are the odds of this? I’d say quite long, since you’ve been posting such reliable returns all these years.
But Madoff posted reliable returns also, you say! Without a doubt, Madoff came closer than any before, (that we know of) to pulling off the perfect Ponzi. I’m reasonably sure, though, that early on he violated Rule 1 – put the money in cash - and possibly rule 2 - don’t be crazy-greedy. While all the details aren’t in, I think it’s likely that Madoff blew some money in the market at some point, maybe in the late 80s or early 90s, and this was probably his undoing. He did run a large broker/dealer, after all, and no doubt thought he knew a thing or two about making money. As for the greedy part, that’s a more interesting question. I mean, of course he was greedy, but it may be that the amount he spent on himself, despite the yachts and villas, was not over-the-top relative to the amount of money his firm was allegedly making. His far-flung homes were – relatively – modest and his apartment in New York is on Lexington Avenue, not an address associated with moguls. I actually think he was more motivated by prestige than money, but I’ll leave that call to others. Let’s just agree to call him a disgusting pig.
What’s relevant was how well he had managed his funding gap. From the available information, he managed it better than anyone else ever has, who’s been caught, anyway. His key insight was his understanding of Rule 1: don’t claim ridiculous returns. Most Ponzsters aren’t particularly bright, or lack patience, so they claim to make 50% every 90 days, or whatever. Most Ponzsters, in fact, break all three of our rules. Madoff, merely by grasping Rule 1, was able to perpetuate his scam for decades.
An interesting question is, what was Madoff’s actual funding gap? From anecdotal evidence surrounding redemption requests prior to the scam being revealed, I’m betting it was close to 75% or 80%. That’s clearly in the danger zone.
Now here's how to get out of the whole thing before you get caught: simply have a terrible year. 2007 was a very troublesome year for many hedge funds. Madoff could have seized the opportunity to say, oops, my models failed me. Sorry, but I lost 75%. I strongly suspect he would have gotten away with this.
So there you have it, a road map. I was going to say you might want to come up with a plausible investment strategy to go along with it, but that doesn’t seem to matter much to gullible investors.
(Note: one key assumption I have made is that the bogus fund raises 10% of new capital each year. Clearly, this number would vary (and occasionally be negative), but I think it’s reasonable, perhaps conservative, given the claimed returns. Also, for simplicity’s sake, I have assumed straight-line 10% returns. The smarter thing to do, post-Madoff, would be to have some variability, but not so much as to scare investors away.)
Sunday, January 25, 2009
Hedge Fund Outlook for 2009 - Say What?
If there was one over-arching lesson from 2008 it might be that every time we – I use a society-wide “we,” here - think we have learned how to control risk, we discover we haven’t. But how can we, really, if risk is tied to the market’s animal spirits, something that will never be quantifiable since it is wholly a bi-product of the human psyche.
But frankly, what scares me more than risks we can’t control is the current impulse, from a governmental point of view, to try and do just that. Free market capitalism is still the most efficient and moral way for a society to organize itself, so one fears there may be medicine coming that, in the desperation for “an answer,” turns out to be worse than the original problem. Beltway panjandrums are surely enjoying this sudden windfall of authority. This is disconcerting, because the halls of Congress are not burdened with economic literacy. You might respond that this affliction runs high on Wall Street as well, to which I would say, touché. Like William Goldman once famously said of the movie industry, no one knows anything.
Let’s pretend we do and turn our attention to what’s ahead.
The Outlook for hedge funds...
Let me start this with something that will sound, on the surface, somewhat shocking: the outlook for hedge funds for the next few years is as favorable as I can imagine. Notice I did not say the outlook for the hedge fund industry, for that’s another matter. No one’s head is in a place, psychologically, where they’re ready to hear this, so the industry as a business will continue to suffer. However, as I ponder what drives hedge fund returns, I can come to no other conclusion than we are entering a multi-year period of 20%-like returns, starting probably after the next redemption cycle is complete at the end of March. Let’s go through the salient points:
1. Market volatility is high, but not crazy-high. Hedge funds like volatility because it causes investors to make sub-optimal decisions which, in turn, create price inefficiencies. Mind you, volatility like October’s – where all security prices are affected indiscriminately - makes it near impossible for anyone to operate. But this is very rare. Plain vanilla high vol is a good thing.
2. Somewhat related to the previous point, market inefficiencies are as glaring as I’ve ever seen. Bonds priced like the whole world’s going bankrupt, munis trading way cheaper than governments…it’s a long list. Understand that it’s not just that prices are cheap, it’s that they don’t make sense, particularly when compared with each other. This contrasts markedly to the generally “efficient” market we saw during the bull market.
3. Borrowing costs are at an all-time low. Almost all hedge funds borrow money to one degree or another. If a fund borrows 1-1 on its portfolio, a two point reduction in margin rates results in a two point improvement in its performance, all other things being equal. Almost no one is pointing this out.
4. The competition has gone ka-blooey (little bit of industry lingo, that). This is the biggest point of all, so just in case you forget points 1 -3, remember this one.
When I ran my own hedge fund, I got out in ’06 because there was just too much money in my strategic space. In my case it was quant, a sector that was being overwhelmed by the likes of DE Shaw and Renaissance. But the same thing was happening across all hedge fund sectors. Too much money reduces opportunity and increases risk. This is particularly true of spread-driven arbitrage strategies where everyone is looking at the same trades. But now the opposite is occurring.
Let me take you through some numbers as estimated by Peter Douglas, an industry professional based in Singapore. He estimates that until a few months ago, there was $6 trillion of “alpha seeking” capital in the world, $4 trillion of which was on bank proprietary trading desks and $2 trillion in hedge funds. The hedge funds, he figures, were levered 3 – 1 (on average) while the prop desks more like 20 -1 (if that seems like a crazy number, consider that Bear and Lehman were levered, as institutions, 30 -1). Do the multiplication and you get to $86 trillion of hedge-fund-like money in the world. No wonder it was getting tough to find good trades!
Douglas predicts a third of the hedge funds are vaporizing as well as 75% of the prop desks. This brings the number down to $24 trillion. But don’t stop there. Whoever’s left in the game will have delevered considerably. Douglas guesses hedge funds take it down to 1 1/2 – 1 and banks 10 – 1. This brings our number all the way down to $12 trillion, an unfathomable 86% decrease.
You can quibble with the numbers a bit if you want, but people I talk to think that he may even be underestimating by a bit. Whatever, the industry has all but disappeared, which makes me naturally think of…Bubba Gump Shrimp.
I’m sure you saw Forrest Gump. If you didn’t, there’s a scene where Forrest and a friend, who have scrapped together some money to buy a shrimp boat, take it out in the middle of a hurricane. While this seemed foolish, all the boats tethered to their docks are smashed to bits, and Forrest finds himself with the only boat in the Gulf. All the shrimp were theirs for the taking, and the Bubba Gump Shrimp Company went on to riches and fame.
We’ve been pondering this a great deal in our office. Those able to stick around in the hedge fund business will get all the shrimp or, more precisely, feast on spreads big enough to drive a truck through. It will resemble the early-middle 1990s, the days before your cleaning lady quit to start a fund.
Interestingly, this bull market for hedge funds is likely to occur while the stock market goes nowhere. I don’t pretend to know where stocks are going, but this recession will be long and deep, so it’s hard to make the case for a bull market anytime soon. Big trading rallies, sure, but not a secular bull market. (Of course, as a naturally bullish person, I recognize my own possible utility here as a contrary indicator.)
Many people want to know how long the economic pain will last. First, let me say, that we no longer appear to be staring off the edge of the cliff the way we were in October, when we had a global counterparty crisis that could have ended much worse than it did. Think a run on all the world’s banks. It was close, maybe days away. Now, it’s not as if everything’s better, but at least it’s a problem that we can get our arms around, namely a recession. Recessions, unpleasant they may be, are a part of life. We’ve had them before, and we’ll have them again. This one will be a bad one, for sure, but at least the world’s not coming to an end.
So how bad will it be? I find a good starting point is some historical context. Here is what the recessions have looked like for the last 100 years or so:
Note that the average recession lasts 13 months. Our current recession actually started in December, 2007. I know it feels like it just hit this fall, but that’s the reality of it, according to the National Bureau of Economic Research, which means by February this recession will already be long in the tooth. Also note that with current unemployment rate of 7.2%, we have almost reached the average on that score as well. But no one thinks this recession is going to be average.
Our longest recession was actually the Great Depression at 43 months. I’m going to say this one will last 20 months or so, which would make it the longest since. But this means we’re out of it by July. Why do I say this? I am but an armchair economist, after all. But there’s just too much stimulus being thrown at the problem for the economy not to stir. In the Depression, they raised taxes and cut the money supply, both painful mistakes. Lesson learned. Bernanke, a student of the Depression, will juice the money supply like never before. He knows that given a choice of a bad recession and a depression, you take the bad recession every time. And Obama looks like he won’t raise taxes any time soon, despite his original plans. So, all in all, some nastiness for ’09 with 8-10% unemployment, if I had to guess.
It’s an open question, though, as to what awaits on the far side. Unfortunately, I don’t think it’s a v-shaped recovery. All in all, it looks a lot like…
It’s always worth remembering Twain’s famous quote about how while history never repeats itself, it rhymes. In that spirit, let’s hope we see no more album covers like the one above (side note: the guy in the middle is my Congressman, whom, on account of my highly developed sense of fashion, I could not support). But there are some looming similarities between now and the 70s that are too pressing to ignore. The one that sticks out for us is the prospect for inflation. My partners and I think 10% inflation is possible a year or two out. (We don’t always agree, but we agree on this.) The printing presses will be working overtime to pay for everything that’s being promised. Many are also forgetting one other thing: the tidal wave of baby boomer entitlements that looms in the not-too-distant future. Keep those presses humming!
Another way to think of it is to ask yourself, who wins and who loses when inflation accelerates? In a nutshell, borrowers win, and lenders lose. Think of inflation as a wealth transfer from lenders to borrowers. Who is the biggest borrower in the world, and getting bigger by the second? The U.S. Government. Who is the biggest lender? After us, it is Japan and China. From a purely self-interested point of view, what would you do, if you were the U.S. Government?
But frankly, what scares me more than risks we can’t control is the current impulse, from a governmental point of view, to try and do just that. Free market capitalism is still the most efficient and moral way for a society to organize itself, so one fears there may be medicine coming that, in the desperation for “an answer,” turns out to be worse than the original problem. Beltway panjandrums are surely enjoying this sudden windfall of authority. This is disconcerting, because the halls of Congress are not burdened with economic literacy. You might respond that this affliction runs high on Wall Street as well, to which I would say, touché. Like William Goldman once famously said of the movie industry, no one knows anything.
Let’s pretend we do and turn our attention to what’s ahead.
The Outlook for hedge funds...
Let me start this with something that will sound, on the surface, somewhat shocking: the outlook for hedge funds for the next few years is as favorable as I can imagine. Notice I did not say the outlook for the hedge fund industry, for that’s another matter. No one’s head is in a place, psychologically, where they’re ready to hear this, so the industry as a business will continue to suffer. However, as I ponder what drives hedge fund returns, I can come to no other conclusion than we are entering a multi-year period of 20%-like returns, starting probably after the next redemption cycle is complete at the end of March. Let’s go through the salient points:
1. Market volatility is high, but not crazy-high. Hedge funds like volatility because it causes investors to make sub-optimal decisions which, in turn, create price inefficiencies. Mind you, volatility like October’s – where all security prices are affected indiscriminately - makes it near impossible for anyone to operate. But this is very rare. Plain vanilla high vol is a good thing.
2. Somewhat related to the previous point, market inefficiencies are as glaring as I’ve ever seen. Bonds priced like the whole world’s going bankrupt, munis trading way cheaper than governments…it’s a long list. Understand that it’s not just that prices are cheap, it’s that they don’t make sense, particularly when compared with each other. This contrasts markedly to the generally “efficient” market we saw during the bull market.
3. Borrowing costs are at an all-time low. Almost all hedge funds borrow money to one degree or another. If a fund borrows 1-1 on its portfolio, a two point reduction in margin rates results in a two point improvement in its performance, all other things being equal. Almost no one is pointing this out.
4. The competition has gone ka-blooey (little bit of industry lingo, that). This is the biggest point of all, so just in case you forget points 1 -3, remember this one.
When I ran my own hedge fund, I got out in ’06 because there was just too much money in my strategic space. In my case it was quant, a sector that was being overwhelmed by the likes of DE Shaw and Renaissance. But the same thing was happening across all hedge fund sectors. Too much money reduces opportunity and increases risk. This is particularly true of spread-driven arbitrage strategies where everyone is looking at the same trades. But now the opposite is occurring.
Let me take you through some numbers as estimated by Peter Douglas, an industry professional based in Singapore. He estimates that until a few months ago, there was $6 trillion of “alpha seeking” capital in the world, $4 trillion of which was on bank proprietary trading desks and $2 trillion in hedge funds. The hedge funds, he figures, were levered 3 – 1 (on average) while the prop desks more like 20 -1 (if that seems like a crazy number, consider that Bear and Lehman were levered, as institutions, 30 -1). Do the multiplication and you get to $86 trillion of hedge-fund-like money in the world. No wonder it was getting tough to find good trades!
Douglas predicts a third of the hedge funds are vaporizing as well as 75% of the prop desks. This brings the number down to $24 trillion. But don’t stop there. Whoever’s left in the game will have delevered considerably. Douglas guesses hedge funds take it down to 1 1/2 – 1 and banks 10 – 1. This brings our number all the way down to $12 trillion, an unfathomable 86% decrease.
You can quibble with the numbers a bit if you want, but people I talk to think that he may even be underestimating by a bit. Whatever, the industry has all but disappeared, which makes me naturally think of…Bubba Gump Shrimp.
Shrimp Creole, shrimp gumbo, coconut shrimp…
I’m sure you saw Forrest Gump. If you didn’t, there’s a scene where Forrest and a friend, who have scrapped together some money to buy a shrimp boat, take it out in the middle of a hurricane. While this seemed foolish, all the boats tethered to their docks are smashed to bits, and Forrest finds himself with the only boat in the Gulf. All the shrimp were theirs for the taking, and the Bubba Gump Shrimp Company went on to riches and fame.
We’ve been pondering this a great deal in our office. Those able to stick around in the hedge fund business will get all the shrimp or, more precisely, feast on spreads big enough to drive a truck through. It will resemble the early-middle 1990s, the days before your cleaning lady quit to start a fund.
Interestingly, this bull market for hedge funds is likely to occur while the stock market goes nowhere. I don’t pretend to know where stocks are going, but this recession will be long and deep, so it’s hard to make the case for a bull market anytime soon. Big trading rallies, sure, but not a secular bull market. (Of course, as a naturally bullish person, I recognize my own possible utility here as a contrary indicator.)
Many people want to know how long the economic pain will last. First, let me say, that we no longer appear to be staring off the edge of the cliff the way we were in October, when we had a global counterparty crisis that could have ended much worse than it did. Think a run on all the world’s banks. It was close, maybe days away. Now, it’s not as if everything’s better, but at least it’s a problem that we can get our arms around, namely a recession. Recessions, unpleasant they may be, are a part of life. We’ve had them before, and we’ll have them again. This one will be a bad one, for sure, but at least the world’s not coming to an end.
So how bad will it be? I find a good starting point is some historical context. Here is what the recessions have looked like for the last 100 years or so:
Note that the average recession lasts 13 months. Our current recession actually started in December, 2007. I know it feels like it just hit this fall, but that’s the reality of it, according to the National Bureau of Economic Research, which means by February this recession will already be long in the tooth. Also note that with current unemployment rate of 7.2%, we have almost reached the average on that score as well. But no one thinks this recession is going to be average.
Our longest recession was actually the Great Depression at 43 months. I’m going to say this one will last 20 months or so, which would make it the longest since. But this means we’re out of it by July. Why do I say this? I am but an armchair economist, after all. But there’s just too much stimulus being thrown at the problem for the economy not to stir. In the Depression, they raised taxes and cut the money supply, both painful mistakes. Lesson learned. Bernanke, a student of the Depression, will juice the money supply like never before. He knows that given a choice of a bad recession and a depression, you take the bad recession every time. And Obama looks like he won’t raise taxes any time soon, despite his original plans. So, all in all, some nastiness for ’09 with 8-10% unemployment, if I had to guess.
It’s an open question, though, as to what awaits on the far side. Unfortunately, I don’t think it’s a v-shaped recovery. All in all, it looks a lot like…
The Me Decade
It’s always worth remembering Twain’s famous quote about how while history never repeats itself, it rhymes. In that spirit, let’s hope we see no more album covers like the one above (side note: the guy in the middle is my Congressman, whom, on account of my highly developed sense of fashion, I could not support). But there are some looming similarities between now and the 70s that are too pressing to ignore. The one that sticks out for us is the prospect for inflation. My partners and I think 10% inflation is possible a year or two out. (We don’t always agree, but we agree on this.) The printing presses will be working overtime to pay for everything that’s being promised. Many are also forgetting one other thing: the tidal wave of baby boomer entitlements that looms in the not-too-distant future. Keep those presses humming!
Another way to think of it is to ask yourself, who wins and who loses when inflation accelerates? In a nutshell, borrowers win, and lenders lose. Think of inflation as a wealth transfer from lenders to borrowers. Who is the biggest borrower in the world, and getting bigger by the second? The U.S. Government. Who is the biggest lender? After us, it is Japan and China. From a purely self-interested point of view, what would you do, if you were the U.S. Government?
Wednesday, January 21, 2009
Travelogue - Houston
Despite knowing a number of people here, I had never before traveled to Houston, America’s fourth largest city (a fact oft quoted here and little known elsewhere). After two days of meetings, lunches, and dinners, it’s clear that this is a town with its own rhythms, economic and otherwise. It is reassuring to know our whole country is not a complete slave to the same economic cycles.
Not that it’s all wine and roses here. Houston can’t stomach a 78% drop in oil without catching a cold. But this is a town that remembers well the boom and bust of the 70s and 80s and has modified its behavior accordingly. No one here thought $147 oil was going to last. A more cynical view might be that the run-up in oil was so fast that no one had a chance to make stupid lifestyle decisions. Either way, the real estate market here has held up and the restaurants are full.
As a free-marketer, it’s hard not to have some affection for Houston. There are no zoning laws, for instance. What sounds (to some) like a recipe for developmental chaos somehow self-organizes in a way that makes sense, and it also removes an entire layer of political corruption. Also, nearly everyone I met felt it important to tell me that Houston is a true meritocracy; come, work hard, succeed. They note that this is very different from Dallas and many other southern cities.
Nearly everyone here is a civic booster, which is refreshing coming from New York, a city that elicits complex emotions from its own even in the best of times.
Last night I attended a large black tie fundraiser to mark the awarding of the Dr. Denton Cooley Award to Dr. Michael DeBakey. Cooley and DeBakey are two of the giants of the medical world, and both are based here (where there is a huge medical research community). In recent years, a great feud had erupted between them, something everyone around the world with any connection to the medical community apparently followed like a soap opera. In Houston, the feud had practical implications because it hampered collaborative research.
In recent months, they reconciled at long last. The award, from one to the other, was to make it “official,” but sadly, Dr. DeBakey died just before he could receive it, so it was awarded posthumously.
Dr. Cooley is quite a character himself. He was once allegedly asked who the best surgeon he’d ever seen was, and he replied, in full drawl, “Well I am, of course.” Frustrated, the interviewer asked who the second best was.
“Me, when I’m drunk.”
Not that it’s all wine and roses here. Houston can’t stomach a 78% drop in oil without catching a cold. But this is a town that remembers well the boom and bust of the 70s and 80s and has modified its behavior accordingly. No one here thought $147 oil was going to last. A more cynical view might be that the run-up in oil was so fast that no one had a chance to make stupid lifestyle decisions. Either way, the real estate market here has held up and the restaurants are full.
As a free-marketer, it’s hard not to have some affection for Houston. There are no zoning laws, for instance. What sounds (to some) like a recipe for developmental chaos somehow self-organizes in a way that makes sense, and it also removes an entire layer of political corruption. Also, nearly everyone I met felt it important to tell me that Houston is a true meritocracy; come, work hard, succeed. They note that this is very different from Dallas and many other southern cities.
Nearly everyone here is a civic booster, which is refreshing coming from New York, a city that elicits complex emotions from its own even in the best of times.
Last night I attended a large black tie fundraiser to mark the awarding of the Dr. Denton Cooley Award to Dr. Michael DeBakey. Cooley and DeBakey are two of the giants of the medical world, and both are based here (where there is a huge medical research community). In recent years, a great feud had erupted between them, something everyone around the world with any connection to the medical community apparently followed like a soap opera. In Houston, the feud had practical implications because it hampered collaborative research.
In recent months, they reconciled at long last. The award, from one to the other, was to make it “official,” but sadly, Dr. DeBakey died just before he could receive it, so it was awarded posthumously.
Dr. Cooley is quite a character himself. He was once allegedly asked who the best surgeon he’d ever seen was, and he replied, in full drawl, “Well I am, of course.” Frustrated, the interviewer asked who the second best was.
“Me, when I’m drunk.”
Tuesday, January 20, 2009
Madoff/Fairfield Update
I rushed out a letter on this subject last month and I’m thinking it got circulated around a bit, as I subsequently saw many references to Madoff’s golf scores, and now many others seem to be calling the Fairfields and Tremonts “enablers” as well. My view on the affair hasn’t changed: con men come and go, but it was irresponsible third party fund raisers who made this one the biggest con job in human history. Few end investors bothered to do due diligence themselves on Madoff since such respectable groups had presumably checked him out.
What’s kind of interesting, sociologically, is how big this story remains. The media are breathless, and bloggers are ferreting out every conceivable angle. I personally know a score of people who are addicted to every new scrap of new information, and they are not disappointed with what each new day offers. Just the other day it was revealed that Madoff’s own sister lost a pile. Wow, that is cold. And just yesterday, a small item on Fairfield Greenwich jumped out at me. They had a close relationship with Union Bancaire Privée, a Swiss bank that had its own Madoff feeder fund. Apparently, three of Fairfield’s other funds-of-funds - the ones that theoretically had nothing to do with Madoff - had money in this feeder. Huh? Fairfield had direct access to Madoff, so why would it pay someone else for access? One guess is that it was some kind of quid quo pro arrangement; Fairfield and Bank Privée did business on a number of levels, so perhaps they were getting a fee break somewhere else, perhaps on advisory services their management company was receiving from Privee. Very bad. Another possibility is that this was a way to channel money to Madoff from other Fairfield funds without letting this fact be completely clear to investors (i.e. ones that had possibly taken a pass on the direct Madoff feeder). Also very bad.
Fairfield’s already the subject of three class actions on its Madoff feeder (the Sentry Fund). Me thinks the other investors will sue also once they figure all this out. I harp on this because these “feeders” have given the entire industry a black eye and they deserve whatever’s coming to them.
Monday, December 15, 2008
Ship of Fools - Madoff and His Enablers
The Madoff scandal has so many facets, it is difficult to know where to start. The sheer size of it is mind boggling. Many thought that the initial $50 billion number, which came from Madoff himself, was likely an exaggeration, but as of this writing, it may not be. I think back to Ivan Boesky, the singular scammer of the 1980s. I think he managed a few hundred million.
Is this a hedge fund scandal? I think you’d have to say that it is, despite the fact that Madoff did not, himself, run a hedge fund. He accepted brokerage accounts, which he then managed through his own brokerage firm. But many formed de facto hedge funds around Madoff for the sole purpose of feeding money to him.
Scammers will always be with us. It should not be shocking to anyone that there are those willing to lie and cheat to make money. Bernie Madoff is simply the latest of a long line of con men: Charles Ponzi, Bernard Cornfeld, Ivan Boesky, Sam Israel, Dana Giachetto, Raffaello Follieri (Anne Hathaway’s boyfriend)…it’s a long list.
Is he smirking?
Charles Ponzi
What’s different here is how large this one got before it folded. What made this possible? Answer: the enablers. These were the large feeder funds set up by others who sold access to the Madoff money machine. What culpability do they have in all this? A lot, me thinks. It comes down to reasonable expectations for due diligence.
I should say that no one is ever going to be 100% immune from the possibility of fraud, including us. But there are two basic lines of inquiry in this business that will keep you out of 90% of the frauds:
1. Who is the auditor? Have you ever heard of them? Do they have other reputable clients? Are they independent of the hedge fund?
2. Who is the prime broker? Are they a recognized name in the industry? Are they independent of the hedge fund?
A weak answer on either of these issues is enough for any smart investor to walk away.
Remember Bayou? They owned their own accounting firm, which made it easy to issue false audits. While cross ownership may have been difficult to uncover, it was a simple matter to determine that the accounting firm, “Richmond Fairfield Associates,” was an unknown entity. Also, Bayou owned its own broker-dealer, through which it did 100% of its trading. This is a problem in two ways. First, you don’t have an independent third party verifying and custodizing the assets. Second, it’s a trading conflict-of-interest. Is the fund getting best execution? Unlikely.
Let’s add to these red flags a yellow flag: overly smooth returns. I say yellow because there are one or two reputable ways to make money that produce fairly stable returns (most of the time), but these are in the lending area, not trading. Any trading strategy that produces month after month of steady returns is a blow-up waiting to happen, either from a shift in markets or because it was just a fraud to begin with. Bayou, naturally, had very smooth returns. The point is, smooth returns should, at a minimum, evoke some very pointed questions about the underlying strategy. My personal recommendation: How the heck do you do that?
How would Madoff have stood up to these questions? Well, Madoff’s auditor, Friehling & Horowitz, is complete unknown. But wait, it gets better. They operate out of a single 13 x 18 foot office located in a strip mall in Rockland County, NY. I looked it up on Google Earth:
They apparently had three employees, one of whom was 80 years old and another was a secretary.
Madoff owned his own broker dealer and charged a commission on every trade. He was, in fact, quite open about it. It was how he said he made all his money. He left the management and 20% incentive fees, incredibly, to the feeders.
Madoff had insanely smooth returns. Here’s what one of the feeder funds looks like:
Only five down months in two decades. Pretty good for a trading strategy, assuming it was possible, which it isn’t. Not even with $1 million, let alone $50 billion.
Which brings me back to the feeders. The feeders are the truly remarkable part of the story, since there were a number of them, and the level of negligence is breathtaking.
The largest feeder was the Fairfield Greenwich Group, with about $7.5 billion in Madoff through its Fairfield Sentry Fund. Here’s what it says about due diligence on their website:
FGG's due diligence process is deeper and broader than a typical Fund of Funds, resembling that of an asset management company acquiring another asset manager, rather than a passive investor entering a disposable investment.
A number of areas of inquiry are examined by a team of FGG professionals who specialize in evaluating respective areas of risk. Typically, a manager has been investigated and monitored for six to 12 months before that firm can be accepted onto the FGG platform. Long negotiating periods enable FGG to be more confident of its decisions before proceeding with a manager. Areas of examination are centered around the following:
1. Portfolio Evaluation, Investment Performance, and Financial Risks:
A core area for further analysis is to attempt to dissect and further understand investment performance, how a manager generates alpha, and what risks are taken in doing so. As portfolio management and risk management incorporate elements of both art and science, FGG applies both qualitative and quantitative measures. FGG:
· Examines independent prime broker trading records
· Conducts detailed interviews to better understand the manager's methodology for forming a market view, and for selecting and exiting core positions
· Analyses trading records
· Conducts a number of qualitative and quantitative tests to determine adherence to risk limits over time
· Confirms portfolio loss risk controls, diversification and other risk-related control policies, as well as any experience regarding unexpected or extreme market events
· Reviews the risk and return factors inherent in the strategy
· Evaluates capacity issues, which may affect alpha, as well as expected opportunities going forward within each candidate's strategy
· Analyses the various drivers underlying a particular portfolio's risk
· Evaluates credit risk and market risk both at the instrument and portfolio level
· Assesses the extent to which leverage is used by a manager, as well as how it is used, the funding sources, and the impact on the risk profile of the fund
· Investigate whether or not private or special registration securities are held, and determine how the daily trading volume and inventory held compares to the float and/or daily trading volume for a given security
FGG also conducts many quantitative reviews of investment performance in light of:
· Fees and fee structure
· Historical draw-downs
· Return volatility
· Commissions earned
· Performance return in calm versus volatile markets
· Current/historical correlation of the fund under consideration with standard industry benchmarks, peer groups, and other FGG or competitor funds used as benchmarks
FGG attempts to understand the return attribution for individual securities in the portfolio, and conducts a full suite of VaR analyses and stress tests to model the loss distribution function under extreme market scenarios. Leverage, concentration limits, and long/short exposures are examined over time to assess whether they have remained within operating guidelines.
Style fidelity is another key area of inquiry; the manager's trading pattern over time and through various market environments, FGG determines whether the manager is prone to trade outside of their area of expertise.
2. Personal Background Investigation:
FGG examines the abilities and personalities of the individuals involved in managing the fund through extensive interviews, as well as background investigations.
FGG verifies:
Education
Personal credit standing
Litigation and regulatory background
Track record
Other indicators
FGG explores the manager's experience and qualifications relative to the strategy being managed. Prior professional associations of a manager's key personnel can be crucial in understanding a person's experience and character and how they run their investment management business.
3. Structural and Operational Risk:
"Operational risk" refers to the risk of loss resulting from inadequate or failed internal processes, human resources, or systems, or from external events. Operational failures, including misrepresentation of valuations and outright fraud, constitute the vast majority of instances where massive investor losses occur. Other operational risks include staff processing errors, technology failure, and poor data.
Pricing models, as well as the adequacy, independence, and transparency of valuation procedures, contingency plans, and other trading and settlement procedures are all matters for close scrutiny by FGG professionals.
FGG seeks a sound understanding of whether a hedge fund possesses key controls in the areas of portfolio management, conflicts of interest, segregation of duties, and compliance. FGG carefully assesses the controls and procedures that managers have in place and seek to determine actual compliance with those procedures, often suggesting modifications, separations of responsibilities, and remedial staff additions.
4. Legal, Compliance, and Regulatory Risk:
FGG's legal, compliance, and accounting teams specialize in investment management regulation, securities compliance, corporate operations, and tax issues. Hedge fund managers function within an ever more complex legal and regulatory landscape, and the role of this part of the diligence exam is to determine the seriousness of any deficiencies in this area which may cause risk of sanction, loss, or reputational embarrassment.
Both in-house and retained legal professionals interview the management and staff of the manager, research regulatory filings, and review corporate organizational documents, as well as fund memoranda and related material contracts.
Wow, sure sounds good. No stone left unturned there! Except for the fact that they couldn’t have done any of these things. Clearly, no one ever made the one hour drive from New York to Rockland County to visit “Friehling & Horowitz,” although perhaps they were waylaid by the Dunkin Donuts next door. Frankly, I’m amazed FGG’s website is still up because it’s a plaintiff attorney’s dream.
The true winner of the Bozo the Clown award for Dysfunctional Investing, though, must go to Fred Wilpon. His company, Sterling Stamos, was in both Madoff and Bayou. Ask yourself, wouldn’t the Bayou experience cause you to ask some basic questions about your due diligence process? Wouldn’t you then make a change or two? Maybe? Perhaps the annual collapse of the New York Mets proved too great a distraction.
Lots of people got into this scam because they assumed, with so many seemingly reputable people involved, that someone, somewhere, had done actual due diligence. While in a perfect world everyone does their own homework, the practical matter is that individual investors rely on intermediaries. Those intermediaries failed them horribly and have given the whole industry its greatest black eye ever.
A few other thoughts on this. I find it highly unlikely that Madoff’s sons didn’t know about the scam. This was simply too big an operation for one person to pull off. Think of the paperwork alone. When the writing was on the wall, I think Madoff let his sons turn him in to give them the veneer of innocence. I could be wrong, but I doubt it.
Also, from the return stream, as well as some very early red flags that some investors threw, it was clear this was a scam from the start. In most of the investment scams that I have seen (see my letter from March), the manager starts out honestly but goes awry. At some point he decides to lie in the hopes of making the money back (I’ll do it just this once…). Madoff was a liar and a cheat right from the start.
Lastly, Madoff’s golf game is as suspiciously consistent as his investment returns:
| Metropolitan Golf Association
| 9.8
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| Name : L Bernard Madoff | |
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