Wednesday, May 12, 2010

To What Extent Should We Bail Out Madoff Victims?

For some time now, I've been thinking about the extent to which victims in a Ponzi scheme such as the Madoff scheme should be bailed out by the government. Given the attention in Congress to reform the regulatory environment of the U.S. financial industry, I think this is a timely topic. Also, I've heard many complaints of Madoff investors who think the government should do more for them. (These complaints have been voiced in both the comments on this blog and in the news). To what extent should the American taxpayers help victims of Ponzi schemes? I know this will be a controversial topic but maybe it will generate some comments. I hope you share your thoughts in the comments!

For starters, today's WSJ has an article that discusses a lawsuit filed by NY Attorney General, Andrew Cuomo, alleging fraud by Ivy Asset Management LLC who was a feeder fund that gave money to Bernie Madoff's Ponzi scheme. The suit claims that Ivy and some of its officers were suspicious of Madoff and had evidence that Madoff could not be legitimate but they kept their investors' money in Madoff in spite of their concerns.

Cuomo is alleging that Ivy knew there was something fishy about Madoff's hedge fund but they kept their clients' money in the fund so as to get the fees that came with taking money from people and giving it to Madoff. One piece of evidence suggesting Cuomo might be on to something comes from an 1998 email where one Ivy executive reportedly said to another:
"Are we prepared to take all the chips off the table, have assets decrease by over $300 million and our overall fees reduced by $1.6 million or more…?"
This email is allegedly part of a discussion about taking funds out of Madoff's scheme because the executives were suspicious that Madoff's operations could not be legitimate.

I personally think all feeder funds were extremely greedy in taking money from investors and giving it to Madoff without exercising much, if any, due diligence for their investors. The operators of the feeder funds ought to return all the money they took from investors since they either didn't ask questions or they did ask questions and knew something was fishy. The story is that Madoff was very ambiguous about how he made consistent returns in good and bad times. If I give money to a hedge fund that claims to be making legitimate investments for me, I expect the fund to do more than just hand the money to someone who promises 15% in good or bad times.

In any case, whether you believe the feeder funds should do more than just take people's money and give it to another fund after taking their cut, I think many would agree that if a fund is giving money to someone that they suspect is doing something fishy, then they are at least negligent if not fraudulent in their investment operations. A more interesting and potentially difficult question is whether individual investors had a hunch Madoff was doing something fishy? If so, what responsibility do they have for their losses and what role should the government have in protecting these individuals?

My guess is that, in addition to the feeder funds, there were several individual investors who gave money directly to Bernie and looked the other way. They were willing to give him their money because they were greedy and wanted something for close to nothing. These investors were hedge fund investors so they were required to be relatively wealthy and should have known that the funds they were investing in were not subject to as much regulation as, say, a typical mutual fund.

An example may be of someone who had $3 million and wanted it to grow to $6 million in five years. They liked Bernie's track record of providing a 15% return in good and bad times. Who wouldn't? However, a little bit of greed can cause someone to go along with something that might sound fishy or even illegal. In those cases, should these investors be protected by other taxpayers?

In my view, the evidence suggests that at least some of Madoff's investors thought he may be using his position as one of Wall Street's top market makers to illegally benefit his fund. In any case, Bernie was offering a great return but was ambiguous about how he generated his returns. It's reasonable that some investors probably thought: "Bernie is a big player on Wall Street and can pull strings to make money in good and bad times. It might be illegal but he needs to worry about that, not me. I'll just give him my money, get my above market return, and live happily ever after."

As evidence that some investors had this mindset, Barron's ran an article in 2001 that showed many people questioned how Bernie could make money using his "split-strike conversion strategy." Among other things, the article says that a former Madoff investor said:
"Anybody who's a seasoned hedge-fund investor knows the split-strike conversion is not the whole story. To take it at face value is a bit naive."
Another quote from the 2001 Barrons article tells more about what Madoff's investors may have been thinking:
Madoff's investors rave about his performance -- even though they don't understand how he does it. "Even knowledgeable people can't really tell you what he's doing," one very satisfied investor told Barron's.
Thus, it appears to me that some of Bernie's investors may have thought to themselves: "Bernie isn't telling me the whole story, even bright people can't explain it, but I don't need (or want) to know as long as he keeps giving me a good return." I question whether this mindset is much different than someone who is offered an opportunity to provide capital to a friend who would guarantee a nice, above market, return on the funds and tells you he imports firewood from Columbia and makes a killing on it. Firewood experts might even say: "We have no idea how he can make that kind of money by importing firewood; maybe he's importing something else that smokes and burns." It appears that some of Madoff's investors would then think: "This definitely sounds fishy but that's his problem, not mine. I just want my above market return."

However, a more ethically sensitive person might say: "There is a reasonable chance this guy is using my money to import illegal drugs and I don't want to support that. I can live on my $3 million just fine; instead, I'll put it in treasuries where I know what is happening with it."

To be fair, it appears that the people who invested with Madoff probably fell into three categories. Presumably, none of the groups knew that Bernie was operating a Ponzi scheme. As such they either: 1) thought Bernie was telling the whole story or they never asked how he purported to make enough to pay them 15% a year in good and bad times (let's call this group the 'blind faith' investors); 2) knew he wasn't telling the whole story and thought there was a chance he was doing something shady with the money; or (let's call these the 'look the other way' investors, 3) knew he wasn't telling the whole story and thought he could legitimately make above market returns in good times or bad (let's call these the 'naive investors').

Many Madoff victims are upset that the government is not helping them with more of their losses. Let's consider the government's responsibilities to these three groups. Personally, I'm not sure that the 'blind faith' investors ought to be protected much if they lose money. These were hedge fund investors who are supposed to be sophisticated and responsible enough to look out for themselves. Also, they meet net worth requirements that allow them to invest in these funds. My understanding is that all these investors are insured up to $500k which seems pretty generous to me given that they handed over money to a hedge fund without asking many questions.

The 'look the other way investors' had asked enough to know something shady was going on. I don't think it's right that taxpayers worry too much about people who are willing to fund illegal operations. Even so, assuming they don't tell anyone that they thought Bernie was a scam, this group also can currently collect up to $500k from SIPC.

The last group, the 'naive investors', asked some questions but didn't really know enough to be skeptical about Bernie's methods. It may also argued that they also did not ask for much advice or look for other opinions or they would have seen one of the Barron's articles or run into the many people who were skeptical. Even so, the SEC didn't shut Bernie down and he was a pretty convincing guy so maybe we can't blame this group for going along with it. Once again though, this group was insured to $500k and they were hedge fund investors who should have been aware of the risks they were taking. As such, although I have the most compassion for this third group, I also believe the $500k insurance is generous and sufficient. Sophisticated investors should know they should ask a lot of questions before handing over more than $500k to anyone and that diversification is one of the best ways to protect against losing money.

In the end, I believe the regulators weren't hearing a lot of complaints from people because many of Bernie's investors were happy to let Bernie do his magic, even if it might be illegal, as long as they got their steady, above market, returns. As such, I question how these same people can expect taxpayers to insure more than $500k of their losses in a vague and shady sounding investment opportunity. I'm just saying....

Now, what are your thoughts?


  1. There has been a tendency in the Madoff affair to impute the victims.
    Read any comments section out in the blogosphere and it is loaded with
    people remarking that they "should have known" and that returns were
    "too good to be true". The most specious example of this was from the
    trustees counsel when David Sheehan rhetorically asked "Why was
    everyone going to Madoff when people ten years ago forgot about the
    SEC? When everyone said it was a Ponzi scheme and a fraud, they didn't
    go to the SEC because they were getting results!"
    Well as this careful scholarly analysis reveals from the Journal of
    Alternative Investments, the individual investor in this fraud lacked
    the financial resources and skill to conduct the careful due diligence
    to reveal this fraud and that even though a very careful analysis
    revealed potential problems in the footprint of the returns, those
    footprints were carefully hidden.

  2. here is the link

  3. Thanks for pointing out that article. My institution has a twelve month delay in in making full-text articles available from that journal, so I am can't really speak to the details of the paper. Still, based on the abstract, the paper argues that problems were detectable based on the pattern of returns, even if they may not have been detectable to the average investor (one thing I would like to know is whether the paper is referring to actual Madoff investors, who would have had greater resources at their disposal to conduct such an analysis, or whether the paper refers to average investors in the marketplace). Indeed, as Mark mentioned above, the popular press wrote several articles highlighting some of the irregularities in Madoff's returns. I don't think the authors would suggest that Madoff's investors had no way of knowing that Madoff's returns may have been shady, especially when popular press articles suggested as much. Instead I read their abstract as arguing that Madoff's individual investors were unlikely to be able to personally perform the kind of analysis that would have exposed red flags in Madoff's returns.

    Do we know how many of Madoff's investors invested through a feeder fund versus making a direct investment?