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 Atlantic Golf Club	9.8 Effective 12/03/2008
Name : L Bernard Madoff

Score History Used T Mo./Yr. Score CR/Slope Diff. * H 05/00 87 72.8/135 11.9 * H 05/99 86 72.8/135 11.0 H 12/98 85 68.8/118 15.5 H 11/98 83 68.8/118 13.6 * H 08/98 85 72.8/135 10.2 * H 08/98 83 72.8/135 8.5 * H 08/98 85 72.8/135 10.2 * H 08/98 84 72.8/135 9.4 H 08/98 89 72.8/135 13.6 * H 07/98 84 72.8/135 9.4 * H 07/98 86 72.8/135 11.0 * H 07/98 85 72.8/135 10.2 * H 05/98 80 68.8/118 10.7 H 03/98 82 68.8/118 12.6 H 03/98 87 68.8/118 17.4 H 03/98 84 68.8/118 14.6 H 03/98 84 68.8/118 14.6 H 03/98 84 68.8/118 14.6 H 02/98 86 68.8/118 16.5 H 01/98 84 68.8/118 14.6 Score Type: H - Home, A - Away, T - Tournament, P - Penalty, C - Combined 9H, I - Internet I golf, and I can tell you that this is impossible. If anything, golf scores have fat distribution tails. Seems the guy was a liar in every aspect of his life.

Through the Looking Glass

I don’t have to tell you that the investment world has gone somewhat insane since I wrote you a month ago. Imagine a margin call has been made on the entire economy, because that’s what’s happened. Our final number for September was down 6.25%. Amazingly, this was about in line with the hedge fund industry. Please note that this is a bit worse than the flash estimate we sent out about a week ago. This is simply because some of our underlying funds revised their numbers. That doesn’t happen often, but neither does a market like this. I was working at Salomon Brothers when the market crashed in 1987. That had an end-of-days feel to it as well, but it passed in a single day. For those in the financial industry – those left – and for investors in general, this has been much harder to stomach. I would anticipate that 25-30% of Wall Street will be laid off in the next six months, and perhaps 3000 hedge funds will throw in the towel. Neither of these are tragic events, macroeconomicly speaking, since the financial industry had become bloated, but there are scores of innocent people involved.

I get annoyed when I hear people talk about the Wall Street “bailout” plan. No one on Wall Street is getting bailed out, they’ve all been taken out and shot. I’m told that one Hamptons broker got nine new listings in a single day. While we may not weep for someone who is selling a summer house, the underlying reason is often that those individuals have been wiped out. Many people on the Street - people we know - are contemplating a vastly changed life, and only a very few had anything to do with our current predicament.

Still, if you have read these letters over the years, you know me to be an optimist, and that’s not changing now. Yes, we will have a recession (likely inflationary), but not a depression. Bad policy turns recessions into depressions. In the 1930s we tightened the money supply, reduced free trade, and raised taxes, all measures that reduced much needed liquidity. Today, we have a global policy response to reduce interest rates and inject liquidity. As of this writing, it appears to be slowly working. I do worry that Obama wants to raise a number of taxes including capital gains, and he is anti-trade as well. Moves in this direction, if he follows through on them, would be serious blunders. I suspect that recent events will undermine his ability to move in this direction (not to mention undermine his ability to implement enormous spending programs like universal healthcare).

Yes, there are more shoes to drop, including the CDS market, about which I warned in last December’s letter. But many things differentiate this from the 1920s or even the 1970s. For one, we always underestimate basic human ingenuity and its ability to transform society and create wealth. Every so often I find it useful – and reaffirming- to think about the incredible technological changes that have occurred since I got out of college. Heck, in 1984 the fax machine seemed miraculous. Where will the next incredible innovations come from? Biotech? Nanotech? New innovations that arise from a 100 fold increase in computational power? The answer is all of the above. Bad government can slow this process but not impede it entirely the way it once could. People and capital are much more fluid than they used to be.

The market has also turned its attention more towards the prospects of a bad recession and away from the credit crisis. Believe it or not, this is a good thing. Recessions come and go, but a possible total collapse of the international banking system definitely counted as peering into the abyss. If – if – we are passed this, then we have much less to worry about.

So life, and markets, will go on. Those that sell now will join others selling in a panic. How often does that work out? I think you know the answer. Securities of all kinds are getting terrible marks. Locking them in by selling isn’t likely to be a winning strategy.

Once we reach the far side, we will be in far better shape as an economy as all the leverage will have been wrung out of the system. I don’t know if you remember my letter of a few months ago where I spoke of visiting Indonesia. In 1997, the Indonesian currency, the rupiah, lost over 90% of its value. Can you imagine how calamitous it would seem if that happened here? Yes, the Indonesian economy suffered for a few years but today, rid of its excesses, it thrives.

There’s also a lot of money around. That certainly wasn’t the case in the 1920s or the 1970s. The sovereign wealth funds are loaded. Individuals have been liquefying. There have been billions of dollars raised for distressed funds over the last few months. There is money to come in and start buying. Which leads me to my next point…

The craziness has led to the most remarkable bargains we have seen in our lifetimes. This is what happens when you have forced liquidations. For example, you will recall we have an investment in a manager that buys SPACs, which are basically t-bills sitting in publicly traded trusts. Right now, because they have sold off, you can buy these with an implicit yield of 15%. Imagine, 15% t-bills! Actual t-bills yield close to zero. How could this be? It turns out that convertible arbitrage hedge funds were the biggest owners of these securities. These funds were just killed in September and are now facing massive redemptions, so they have been selling whatever they can, which includes SPACs. There are few buyers to be had.

Goodbye, Beta People

In the fund world, beta is what the market gives you, either a wind in your sails or in your face. Alpha is return attributable solely to skill. We had an interesting discussion in our office about how there are “alpha people” and “beta people” on Wall Street. In bull markets, Wall Street creates legions of beta people, who prosper because they were assigned to a fortunate desk out of their training programs. It’s always good to be in the right place at the right time, but nowhere so much as Wall Street. Naseem Taleb wrote about this at length in his first book, “Fooled by Randomness.” Well, the beta people are toast. The bloodletting has only just begun. I suspect a lot of alpha people – those who really create value – will get caught up in occupational violence as well, but they should fair a lot better.

What Would Sir John Do?

The late John Templeton was a long time client of mine, and a great man. My annual trips to the Bahamas to see him were ostensibly about my teaching him about what we were doing, but really most of the teaching went the other way. The recent turmoil reminded of something he said to me once. “Scott, I like to help people,” he began. As Templeton was one of the great philanthropists of our time, I expected to hear about his latest charitable initiative. “When they are desperate to buy,” he continued, “I like to help them by selling. And when they are desperate to sell, I help them by buying.”

Had Sir John lived another year, I don’t doubt what he’d be doing right now.

The Emergence of a New Asset Class?

Normally, hedge funds are the most nimble of investors. When market inefficiencies occur, they are often in the best position to exploit them. Right now, because of all the forced selling, there are more blatant market inefficiencies than at any time in our lifetimes, the kind of opportunities hedge funds can only normally dream about. Except, hedge funds are facing their own redemptions, so they are actually among the investors being forced to sell positions at crazy valuations (as in the example I gave with the convertible arb funds selling SPACs). The irony abounds.

What if a fund didn’t have to deal with any redemptions? That fund would be in pig heaven right now. The fact is that many wonderful trades sometimes need time to season. Liquidity providers almost always do better than liquidity consumers. This is something the endowments figured out a while ago. This leads me to how I believe the hedge fund industry must reinvent itself. The new model will have less leverage and longer lock-ups, probably two or three years. In essence, there will be a new asset class between the traditional hedge fund model and the private equity model. There will be the added advantage of emphasizing a longer period over which investors should judge returns. People simply have to be weaned of this need to see steady positive returns every month. I’ve been trying to come up with a catchy name…hybrid funds? Middie funds? Feel free to submit your ideas – perhaps we can name an asset class.

The product will be somewhat difficult to sell, as investors like liquidity (as such, overpaying for it). That’s why these new funds should have a lower fee schedule, probably 1 & 15. That would be a fair deal all around.