Business | Investment
Wall Street insiders and their fools' gold funds
If Bernie Madoff has lost $50 billion (Dh183.65 billion) of other people's money, why did they trust him with it?
- By John Gapper, Financial Times
- Published: 23:51 December 21, 2008
If Bernie Madoff has lost $50 billion (Dh183.65 billion) of other people's money, why did they trust him with it? With hindsight, the whole affair seems deeply implausible. We know nobody produces rock-steady returns of 15 per cent or more, year in, year out unless he or she is either a genius or a crook.
Yet people lined up to entrust their savings to Madoff. Many of them got a tip from a friend or adviser about a Wall Street operator with a great record. The Madoff broker network also included many funds of funds and private banks which oozed financial sophistication.
Why did they fall for it?
It is an old story: the allure of the Wall Street insider. No one thought Madoff was operating a Ponzi scheme but plenty of people thought he had an unfair advantage. He was a former Nasdaq chairman and one of Wall Street's biggest market makers. Enough said.
"We all hoped, but we knew deep down it was too good to be true, right? I mean, why wasn't everyone in on this game if it was so strong and steady?" wrote Robert Chew, one Madoff investor whose wife's family has lost $30 million, on Time.com. "The way it was described to us was that the 'New York people' had a system."
The opportunity
The New York people always do, particularly at the height of a bull market, when it looks as if Wall Street insiders are positioned to make more money than everyone else. Given the opportunity, who would not try to invest with them?
Henry Blodget, a former analyst who was charged with issuing fraudulent research by the Securities and Exchange Commission in 2003 and settled the case by paying $4million, argued on his Clusterstock blog that many Wall Street veterans thought Madoff was up to something.
They did not think he was recycling client funds, according to Blodget; they suspected that he was using inside information from his big market making operation to "front-run" trades for his clients. That would have explained his oddly consistent high returns.
Even if Wall Street did not think so, some of Madoff's millionaire clients probably did.
Madoff point this out himself at a debate last year at the Philoctetes Centre in New York. He first asserted it was "impossible for an (insider trading) violation to go undetected, certainly not for a considerable period of time" because of regulatory safeguards.
He added, however, that this was "something that the public really doesn't understand. If you read things in the newspaper, and you see somebody violate a rule, you say: 'Well, they're always doing this'." Indeed so, and if you are in a country club in Palm Beach or on the shore of Lake Geneva, half of you thinks this is a disgrace and the other half may wonder: "How do I get a piece of the action?"
Madoff's pitch fitted perfectly into the long and ignoble tradition of Wall Street fund managers luring ordinary folk with the promise of hot investments.
Charles Mitchell did so in the 1920s by selling securities through National City Bank's investment banking arm, before foundering in the 1929 crash. The scandal brought on the separation of banks and securities houses in the Glass-Steagall Act of 1933.
The last time it happened on this scale was in the 1960s. That was the era when aggressive mutual funds flourished and hedge funds became well-known investment vehicles.
"The hedge funds of 1965 . . . were Wall Street's last bastions of secrecy, mystery, exclusivity and privilege. They were the parlour cars of the new gravy train," wrote John Brooks in The Go-Go Years, his book about the 1960s stock market mania that culminated in the 1970 crash.
The 1960s had a Bernie, too: Bernie Cornfield, whose Investors Overseas Services mutual fund group was the biggest in the world before, at the end, it tipped into a Ponzi scheme. "Do you sincerely want to be rich?" was this Bernie's question to those who wanted a job.
Comfortable security
Madoff was more subtle than Cornfield, since he was selling to those who were already rich (or fairly rich) and wanted comfortable security more than dazzling but volatile returns. They sought the privileges of hedge fund investment combined with the safety of annuities.
In the real world, you do not get that - or not for long, anyway - but they were offered nirvana. We wonder at their gullibility but two things made him plausible.
First, people had become used to double-digit increases in the value of houses and Wall Street was full of people leaving investment banks to become hedge fund managers. And Madoff presented himself as offering something comparatively modest and reassuring.
Second, he had a network of financial advisers, many of who had invested their own cash, who said investing with Madoff was a privilege. It was a Main Street version of the access that institutional investors and foundations had to private equity and hedge funds.
On the face of it, funds of funds, private banks and investment advisers were simply offering Madoff's services as a skilled veteran of financial markets who had such old-school values that he did not charge hedge fund-style fees.
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