Sesame Street explains the Madoff Scandal

[jducoeur]

Thanks to Between the Lines for the pointer to this lovely little video about economics. Okay, it's probably not really from Sesame Street, and it's not in any way accurate.¹ But regardless of correctness, it is rather viscerally satisfying...

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¹ I find most of the "Madoff is Evil Incarnate" hype to miss the point: the scary thing is that I suspect he simply fell into an easy trap of his own making, and that most people, after the first few steps, would have made just the same decisions he did. The thing about pyramid schemes is that they are easy to start, and *very* hard to stop. You get deeper and deeper so fast that all you can do is keep feeding the monster until it eats you. Indeed, it wouldn't surprise me if it started the same way as the Satyam mess: cooking the books just a little to smooth out a glitch, and then covering over each successive layer until all you have left is the fraud...

Comments

[goldsquare.livejournal.com]

He never invested one dime of that money. That is not the same as "playing a bit fast and loose with cash flow".

The outrage, I fear, comes from being conned.

Some of the economics blogs I read point out that he mostly fleeced the stupid, that every professional investor that investigated Madoff, ran away...

[doubleplus.livejournal.com]

Er, you may want to let them know that's entirely false. Just google "investment funds invested with madoff" and you can find plenty of stories of professional fund managers who invested with Madoff. If he just fleeced the stupid, then "the stupid" and "professional investors" aren't disjoint sets. ;-)

This including some funds that invested exclusively with him, which is pretty close to criminal -- the only service those managers were providing to justify a fee (compared with someone investing with Madoff directly) is doing due diligence, which they obviously didn't do.

[goldsquare.livejournal.com]

I took your challenge - and the result showed vanishingly few funds that did, and just about all of those were "feeder funds". That is to say, the professionals that did it, didn't invest their own money, but that of clients, and were paid directly by Madoff for doing so.

[doubleplus.livejournal.com]

When you're less busy, I'd be interested in some citations. I can only find one professional, J. Ezra Merkin, who is accused of being a Madoff "pal" and hiding the fact that he was investing with Madoff, and no articles that mention anyone being paid by Madoff (lots of managers who took a percentage of the funds invested, though.) On the other side, in the first couple of pages of google results were this, (http://www.reuters.com/article/businessNews/idUSTRE52414820090305) this, (http://www.bloomberg.com/apps/news?pid=20601087&sid=aipTGtffZU1o&refer=home) this, (http://www.marketwatch.com/news/story/unicredits-pioneer-unit-invested-madoff/story.aspx?guid={0B0DE84B-E209-463E-B763-90FD4BAF1294}&dist=msr_1) this, (http://www.haaretz.com/hasen/spages/1046529.html) and this. ()

But basically, the claims that all professional investors avoided him and therefore can label everyone who didn't as "stupid" sound like bluster to me -- the ones who did are posting about how smart they were, and the ones who didn't are understandably keeping quiet, but that doesn't prove they're nonexistent. Yes, from what I've read, if you checked him out the way you're supposed to, it wasn't hard to figure out that Madoff was fishy, but there was a strong social engineering component to the scheme, and it reveals more that plenty of people take shortcuts when they think there's a web of trust than that those taken in were just stupid. I found this column (http://www.latimes.com/business/la-fi-hiltzik16-2009mar16,0,5992464.column) to be a more honest appraisal of how it all happened than either of "Madoff was pure evil" or "only stupid people were fooled." (http://triangle.bizjournals.com/triangle/othercities/austin/stories/2009/02/16/daily27.html)

[goldsquare.livejournal.com]

I'd like to have that free time too, so I could (perhaps) spend it looking up that answer. Or, see my family more. (Startup, doing first release of product this week and next...)

The first article I read on this, some time ago (back when he was first indicted) was that professionals know that when investing, one separates 3 functions: allocation, investment, oversight. That's what I was taught, and what I learned, a long time ago.

Madoff insisted on all three functions being under his complete and absolute control.

As for "paid by Madoff", what I meant was what you said - that they got commissions for placing funds with him. The term is called "feeder funds". That's not unusual (how did you think non-fee investment professionals get paid), but that's not a model for the best possible financial investment advice. It strains the fiduciary relationship too much.

[doubleplus.livejournal.com]

Perhaps I'm misunderstanding -- I read "percentage of funds invested" to mean they took a percentage of the funds clients invested with them (regardless of where they were invested downstream), not that Madoff paid a percentage of the funds invested with him. I certainly could be wrong.

Good luck with surviving the product release -- been there!

[goldsquare.livejournal.com]

If what I read is correct, it was a classic feeder fund, and the firms that placed money with Madoff were compensated directly.

Obviously, lack the time to dig and see if my understanding and recollection are correct.

[jducoeur]

He never invested one dime of that money.

An interesting assertion -- and one that not only contradicts my instincts, but the information I've been able to find. On what do you base it?

As far as I've been able to piece together (and admittedly, so far I haven't seen a single neutral, detailed account that pulls the whole thing together, so it could be wrong), this NPR quote from a few days ago sums it up nicely:

He told Chin that he started falsifying account statements in the 1990s because he felt compelled to meet investor expectations. He built a giant Ponzi scheme to ensure that those expectations would not be dashed. He ended up taking new clients' money to both finance a lavish lifestyle and pay off established clients when they asked for redemptions from their accounts.

Madoff said that when he started falsifying the statements he "believed it would end shortly and I would be able to extricate myself and my clients from the scheme. However, this proved difficult, and ultimately impossible. … As the years went by I realized this day, and my arrest, would inevitably come."

That has the ring of truth to me: it fits the usual pattern of such idiocies quite closely. (It's quite close to how the Satyam mess happened, for example.)

The confession was that this was "basically" a Ponzi scheme -- the reports that it was a pure one seem to be inaccurate, at least until the past few years when it was all falling apart. As far as I can tell, this *was* an investment plan at the beginning, which started fudging the books in order to look more impressive, and things snowballed as usual. I mean, you're talking about a man who was heralded as one of the biggest market-makers in the world: I'm not clear on how you rectify that with saying that he didn't invest anything. Far as I can tell, most of the money was invested for most of that time -- it's just that the returns on those investments had nothing much to do with the returns he was paying out. And by the end, it all flowed out of the investments into redemptions to those who got out while the getting was good.

If you've got reliable accounts to the contrary, I'd like to hear them -- like I said, I'm seeing an awful lot of speculation, and precious little fact. (And I *have* done a decent amount of digging around, trying to find those facts: Google is failing to produce them.) But I'm skeptical about the "this was all an intentional fraud from the beginning" theory. The "a little fraud leads to ever-bigger ones" model is much more typical of these cases, and so far matches what I've been able to find...

[goldsquare.livejournal.com]

Going crazy at work, so I have no time to tie the citations down. But there was a lot of reliable sounding information on both the New York Times web site, and Ritholtz.com about how the SEC could find nothing to support evidence that he invested, and if I recall, his allocution said the same thing.

[goldsquare.livejournal.com]

And I can't remember - but a very long article on either Slate or Salon.

[doubleplus.livejournal.com]

Well, there may yet be information to the contrary, but this (http://www.nytimes.com/2009/02/21/business/21madoff.html?ref=business) from yesterday's NYT seems to be from a pretty solid source, not speculation:

The court-appointed trustee who is winding down Mr. Madoff’s business said on Friday that his team had searched records going back almost to 1993 and found no evidence that any securities were bought for investors during that time.

[jducoeur]

Interesting -- that might be the article goldsquare mentioned as well. I'll be keeping my eyes open for further information on this.

OTOH, it does raise the terribly interesting question of where the hell he *was* keeping the money. I mean, the entire point of this particular Ponzi scheme was that he was paying a very steady outgo. Unless he was impossibly good at matching new investors to old, there has to have been a very large float (on the order of billions of dollars) in the middle there. So now I'm rather curious about where it was being held.

(I will admit that my argument has been influenced by an assumption that investing the core funds is the obvious way to float a scheme like this, especially in a bull market; for a market trader like Madoff to have not done so is genuinely surprising and strange. I don't expect him to have invested in the companies he claimed to have, but not to have the money in the market at all is kind of weird...)

[umbran.livejournal.com]

Sir, respectfully - $50 billion dollars, over more than a decade, and skimming off the top all the while is not "an easy trap". It calls for way too much calculation and planning to get that big. Nothing easy about it.

If you try to paint Madoff as a victim of himself here, I shall be forced to laugh at you.

[laurion]

To be clear, $50 billion isn't what investors gave him, it's what he owed them according to the falsified earnings reports he sent out. The real losses here are somewhere between what they gave him, and what he pretended they'd earned. If you take their investments, factor on top a realistic rate of return in sensible investment strategies, rather than the exaggerate and falsified rate he promised, you come up with a more accurate number. Not that I'm defending him in any way, I'm just pointing out that the big numbers being thrown around are being done from a place of emotion and anger (and probably rightly so).

[umbran.livejournal.com]

The real losses here are somewhere between what they gave him, and what he pretended they'd earned. If you take their investments, factor on top a realistic rate of return in sensible investment strategies, rather than the exaggerate and falsified rate he promised, you come up with a more accurate number.

It goes well beyond the difference between what he said you had, and what you should have had if you invested in someone else...

People make plans based upon their assets. Have a tidy sum tucked away for retirement in Madoff's offering? Good, you can use the rest to risk on a business venture! Suddenly, the Maddoff money is gone, and you are operating without a net. Or maybe you were expecting to pay your mortgage out of some of those investments.

Basically, the sudden loss of expected funds can lead to nasty crash and burns that would not happen if they hadn't been lied to - they'd have planned otherwise, this amplifies the effect and impact of the losses significantly.

[laurion]

Oh, I agree that there's more to the loss than just money; but this is true whenever a financial instrument collapses. I was just saying that if people are going to boil it down to a number, they should be aware of which number they are using, and why.

[jducoeur]

Sir, respectfully - $50 billion dollars, over more than a decade, and skimming off the top all the while is not "an easy trap". It calls for way too much calculation and planning to get that big. Nothing easy about it.

Honestly, I disagree. Or, at least, I think it was easier for him than the alternative.

Mind, I'm not defending Madoff here: he's a crook, a cheater and, especially, a coward. But as I responded to goldsquare above, I find it unlikely from what I've been able to find that he set out initially to commit a massive fraud. Rather, the signs point to an initial fraud that probably seemed easy to rationalize at the time -- "Oh, I'll just smooth the books a little, to make the investors happy" -- and then didn't have the nerve to own up to it while the fraud was still small.

Seriously, I suspect many people would fall into the same trap in the same way, after the initial crime. It's simply a matter of waking up, every morning, and asking the same question: "Do I own up to this, go to jail for probably a decade or more, and ruin the lives of my family? Or do I smile blandly, keep defrauding more people, and hope for a miracle that will fix this mess?" It's pretty clear that by the last few years he knew he was doomed, but I'd bet that for quite some time he was rationalizing that It Would All Get Better if he could just hold on long enough -- most fraudsters of this type hold out that hope.

There's an important point here. It's very easy to assert "I'd never do something like that". But if you think answering that morning question is easy, then I submit you haven't really thought about it. You might well do the right thing -- certainly I hope that I would -- but the question is a terrifying one, and simply keeping on going *is* the easier option. For most people, there is very little harder than saying publicly, "I have done wrong".

And the most important point is that great crimes often grow from small ones. This looks to me a *lot* like the Satyam debacle (as well as several other major financial frauds of the past few years), of someone in power convincing himself that cheating just a *little* won't hurt anybody, and then being forced to commit ever-greater crimes in order to cover up the previous ones. The moral of the story is that you have to be especially vigilant to be honest about the little stuff, because it *is* easy to cheat just a little, and it can destroy you in the end...

[laurion]

I'm not sure if he 'simply fell into an easy trap'. He deliberately lied to investors about the rate of returns. He had to falsify earnings reports and mail them out to investors. He promised more returns than he was actually making so he could get more investors to give him capital. If an investor wanted to withdraw their interest or capital, he gave them money from other investors capital. These are not small easy mistakes; these are deliberate decisions that contravene the fundamentals of operating an investment firm. If he'd ever made an attempt to right the sinking ship it would be one thing, but as nearly as anyone can make out he never regretted his actions until he was caught.

[jducoeur]

but as nearly as anyone can make out he never regretted his actions until he was caught.

Could be. It's entirely possible that he really is that much of a sociopath, but I don't think the story I've seen so far requires that. He managed to build up a structure that pretty much required him to just keep going, or it would all collapse pretty fast, and the crime grew ever larger as he went.

I honestly don't see any way he *could* right the ship after those first few years -- he built up the firm on an impossible premise (that he could deliver reliable earnings in an unreliable market), and if he admitted that fundamental untruth, even by having "a bad year", it likely would have led to a run on the fund, destroying it and revealing the crime. So he just kept building it instead.

We'll see -- I'll be very interested to read the full history once it gets properly worked out. But so far, I don't see anything that requires a really sociopathic lack of remorse, just a fair dollop of ordinary moral cowardice and greed...