A Blog About Bernie Madoff

July 11, 2009

What Would Warren Buffett Think About Bernie Madoff?



Warren Buffet, CEO Berkshire Hathaway

Warren Buffet, CEO Berkshire Hathaway












In an exclusive interview with “Good Morning America” on July 10, billionaire investor Warren Buffet, CEO of Berkshire Hathaway, shared three pieces of investment advice. The advices are basic investment maxims. Coming from the “Oracle from Omaha”, they are a reassuring voice in this trying economic time. So I will discuss Buffet’s advices in relation to the Madoff Ponzi scheme.

Buffet’s advices are:

  1. If it seems too good to be true, it probably is.
  2. Always look at how much the other guy is making if he is trying to sell you something.
  3. Don’t go into debt.

I would like to dwell on the first point. I think this is the biggest lesson one can learn from Madoff. The annual returns of Madoff were out sized (any where from 10% to 20% a year and in some cases even higher) and consistent (year after year). This kind of performance should raise a giant red flag.

This meant that Madoff, until the collapse of his firm in December of last year, was a risk-free investment that also had a high rate of returns. This flied in the face of common sense and some of the most basic investment principles.

US Treasury debt instruments and various other cash instruments such as bank CDs are safe and risk-free, thus on the lowest spectrum of the risk scale. As of July 9, one-year Treasury annual yield is 0.54% and 30-year Treasury annual yield is 4.34%. Madoff essentially offered a ultra high yield investment that was also ultra safe. That should make anyone stop and do some checking before handing over the money.

At a higher spectrum of the risk scale is stock investing. Let’s look at S&P 500, an index of 500 large cap US stocks. The index was created in 1926 and is taken by many professionals as the proxy for the US stock market. Since its inception to 2002, the average return in investing in S&P 500 is about 12% annually. In these 76 years, you would not get 12% every year. Being a risky investment, the individual annual returns fluctuated wildly during these 76 years from minus 45% to positive 54%. So Madoff not only beat the market, he did so all of the time (year in and year out, month after month). It might be possible to find fund mangers who beat the market 10 years in a row. But inevitably the winning streak stops at some point. Why would Madoff be any different?

Warren Buffet has stellar investment results too. If you invested $1000 with Buffet in 1959, the accumulated value of that investment would be worth $25 million today, giving you an average 22.45% annual return over this 50-year period. But you would not get 22.45% every year. You would have 10% some years, -5% in some down years and 2% in some not so good years and 50% in some banner years. Over the 50-year period, the annual performances would average out to be 22.45% a year. In other words, real investments tend to have variability in annual and monthly results. This is the case with the two examples we have here – S&P 500 and Berkshire Hathaway. Moving away from stocks, even hedge funds exhibit fluctuated investment results from year to year. For example, with 2008 being a down year, most hedge funds suffered big losses in 2008. It is the lack of variability in annual returns that is the most troubling aspect about Madoff.

Madoff’s ultra high returns and ultra safe investment also flied in the face of the “no free lunch” principle of investing. This is also the “Eat Well, Sleep Well” adage for investment. This refers to the tradeoff between risk and return (reward). If you want to potentially eat well (gaining high return or reward from your investments), you must take on risk that may keep you from sleeping well at night. In contrast, if you want to sleep well (investing in risk-free investments), you will face the certain prospect of not eating well (low rate of return).

The risk-return trade-off described above implies that there is no free lunch. You can have your lunch (high returns) but you need to pay for it by accepting a higher level of risk. In choosing consumer goods, we tend to be skeptical of deals that are too good to be true. Why would investing be any different, especially when you are investing a substantial sum of money?

Some Madoff investors probably explained that Madoff must know what he was doing. He had the secret sauce that others did not have. After all, didn’t he use a proprietary strategy based on the split strike conversion strategy?

There was no secret sauce. Professionals in the investment world are vultures to a large extent. If they see something lucrative, they all want to get in on the act. In fact, Frank Casey, former vice president of marketing for Rampart Investment Management, got wind of Madoff’s fantastic results in the late 1990s and wanted to look for the same secret sauce. He and his colleague Harry Markopolos started out looking for the secret sauce and ended up finding a Ponzi scheme!

Markopolos kept investigating Madoff and later concluded, using the baseball analogy, that Madoff would be like a baseball player hitting 0.925 straight for 10 years in a row. Few people would believe a professional baseball player could do a 0.925 every year. Why would Madoff or anyone else for that matter be any different as an investment manager?

Harry Markopolos dogged the Security Exchange Commission (SEC) for years with his warnings about Madoff. But no one listened to him. This is now a well known story. There is no excuse for the SEC to have missed all the warnings about Madoff. But that is another story for another post in my blog.

The story of Madoff is surely a serious reinforcement of this basic investment maxim given by Buffet. Back when Madoff was still the emperor of his own empire, what did Buffet think about Madoff? I am sure that Buffet, being someone who practices what he preaches, would never invest with someone like Madoff.

I am sure future Ponzi schemers will try to learn from Madoff too. For ordinary investors and fund managers alike, the following Madoff investment lessons are a good foundation to build on. Spotting a Ponzi scheme is not an exact science. But any investor ignores these lessons at his or her own peril. As many Madoff investors found out the hard way, it can be perilous and ruinous not to follow these principles.

Fund managers such as Walter Noel (Fairfield Greenwich Group), Jeffry Picower and Ezra Merkin certainly did not follow such investment principles. They just passed the bucks to Madoff without asking any questions. Why did they not bother with asking simple questions about Madoff? In my view, it is imperative even for ordinary investors to follow these basic investment advice and asking basic questions.

Some Madoff Investment Lessons:

  1. If it seems too good to be true, it probably is.
  2. Don’t put all your eggs in one basket.
  3. Get a second opinion. If you have millions to invest, pay an independent advisor to check out the fund manager.
  4. Do not rely on “collective due diligence”. Just because a fund manager has a stellar reputation in the street, it does not mean no independent verification is needed.
  5. If you do not understand, as a concept, the investment principle used by your prospective fund manager, do not invest in it.
  6. Don’t fall for the limited edition marketing ploy. You should not have to beg someone to take your money. If you have to get the papal dispensation before you can invest (as in the case with Madoff), beware. It all boils down to your goals for investing. Do you want to have the feeling of superiority that comes from joining an exclusive club or do you want to accumulate enough assets for your retirement?
  7. No veil of secrecy around the investment offered by the fund manager. Once again, investment is about accumulating assets and not about joining a secret fraternity. If the prospective fund manager wants you to stay mum about the investment and even its existence (as in the case with Madoff), stay away.

Any comment? Any other basic investment principles that can be helpful to ordinary investors?


June 18, 2009

Madoff Left Plenty Of Clues


Golden Boy Ezra Merkin at a charity event

Golden Boy Ezra Merkin (right) at a charity event

Jeffrey Pico8th from left.wer, 6th from left. His wife Barbara, 8th from left

Jeffrey Picower, 6th from left. His wife Barbara on his left.

Walter Noel, founding partner of Fairfield Greenwich Group

Walter Noel, founding partner of Fairfield Greenwich Group


The fund managers at the feeder funds associated with Madoff are fascinating to watch. The names of Walter Noel, Ezra Merkin, Jeffry Picower come to mind, just to name a few. For a long time, they were considered to be financial geniuses with a golden touch. They were moving in their respective moneyed circles and basking in the adulation of being involved in various worthy causes with many charitable foundations.

Since the gargantuan fraud of Madoff came to light, they have been shunned for the most part in their former habitats. They are no longer financial geniuses. They say so themselves. They were all duped by this bastard called Bernie Madoff. They are in a tough bind here. If they did know Madoff was up to no good, then they stand to face criminal charges. If they were truly duped by Madoff, they are in violation of failing to do due diligence and act a fiduciary on behalf of investors, which is a civil offense. Indeed, these fund managers are now facing multiple civil suits with the goal of retrieving billions of dollars withdrawn from Madoff’s firm.

Watching these former financial geniuses is not all about a smug satisfaction of watching the falling of the mighty, though, I admit, there is some of that. I think it is important for all of us to know how the Madoff Ponzi scheme worked. This is an investment lesson as much as a detective story on the largest financial fraud in history. Bernie Madoff teaches us the importance to be less trusting of investment advisers. This lesson will not be complete if we do not delve in some details into how his Ponzi scheme worked.

What is the lesson of Madoff?

What is the lesson of Madoff?


On the criminal investigation of Madoff, there is not a whole lot of information being released. Frank Dipascali, a lieutenant of Madoff, is supposed to be naming names to the authority. But not much of the details from Dipascali is known publicly. Until we know, we can refer to the court filings from some of the civil cases, which are still eye opening and provide an early look at the inner looking of the Ponzi scheme of Madoff.

In this post, I would like to focus on the phony statements from Bernard L. Madoff Investment Securities (BLMIS).

How did Madoff and his co-conspirators come up with the false trades and the phony statements showing consistent annual returns of 10% to 21% year after year? If one goal of a Ponzi schemer was to produce monthly statements that can stand up to scrutiny by the most seasoned investment professionals, then Madoff failed big time. In fact, the Madoff statements could not even withstand the most basic checks and verification. It turned out that there were plenty of obvious signs that the statements were phony with fictitious trades. These former financial geniuses chose to look the other way.

Though the Madoff fraud was a $65 billion Ponzi scheme, the statements that were generated were amateurish. I am not talking about the quality of the printing. The statements contained errors and inconsistencies on a regular basis. Any investment professional can spot these errors. In some cases, all one needs is access to Yahoo! Finance.

The red flags and inconsistencies reflected in the Madoff account statements that I describe here are detailed in the May 18 court filing made by Irving Picard, the court appointed trustee in the liquidation of BLMIS. This filing details the civil case against Fairfield Greenwich Group (FGG), a major feeder fund for Madoff, where Walter Noel is a founding partner.

Out Of Range Security Prices

Some securities prices in the statements were just plain wrong. In many instances, the statement prices were outside of the actual trading ranges in the days in questions. Take the example of Intel Corporation (INTC) in one statement. The trade date was October 2003 and the price was $27.63. The daily price for Intel on that day was $28.41 to $28.95. Between 1998 and 2008, for Madoff customers of FGG, there were more than 280 purported trades reflected on the monthly statements that were out of range.

Weekend and Holiday Trade Dates

Some trades of securities took place on weekend and holidays, another clear sign of false trades

Unusually High Trading Volumes in Relation to the Market

The trading volumes shown on some statements were too high in relation to the total market volumes, in some cases as much as 50% of the market. I am sure Madoff fancied himself as a big player as a market maker, but not to the point of cornering 50% of the market! For example, the total shares of Coca Cola sold by BLMIS on July 17, 1998 was 1,134,061. The total trading volume of Coca Cola on that day was 2,252,300. This trading activity was just for the feeder fund FGG! From 1998 to 2008, among the FGG customers, there were 180 instances of stock trades shown on BLMIS statements that were in excess of 20% of total market volume.

The purported investment strategy used by Madoff was the so called split-strike conversion strategy. This entails holding stocks in the S&P 100 index while simultaneously buying option contracts on the stocks in this index, which is an index of 100 major, blue chip stocks representing diverse industry groups. In some statements, the amount of option contracts purchased was in the tens of thousands while the total volume of trading in the option market for that contract numbered in the hundreds.

Questionable Trading Practice of Option Contracts

BLMIS claimed to purchase option contracts in the Over The Counter market (OTC) rather using the less expensive option of trading over the Chicago Board Options Exchange (CBOE). Yet the higher trading costs were not passed to investors. Any fund manager at sophisticated hedge funds should at least question such approach.

Perfect Timing in Trading of Stocks

For many years, the BLMIS statements reflected a consistent ability to trade stocks near their monthly highs and monthly lows. According to the May 18 court filing, “No experienced investment professional could have reasonably believed that this could have been accomplished legitimately.”

Returns That Were Too Good To Be True

It is always comforting to live in a universe that is predictable. “Bernie must know what he is doing” may be the usual refrain for some investors. A pattern of generating 10% to 21% annual returns on a consistent basis over decades is simply not credible. Madoff also had very few months with negative returns. In the statements for Fairfield Greenwich Group from 1996 through 2007, only 2.9% of the months were in the negative territories. For comparison, for the 12 years from January 1996 to December 2007, the S&P 500 had a total of 52 months with negative returns (36.1% of the total number of months).

There are plenty of other red flags involving trade data and trading practices as shown in the fictitious statements. Fake statements with consistent numbers are not as easy to create as one would think. The false trades represented an internal Madoff universe of securities. This internal world needed to be consistent within itself and also needed to be reconciled with the corresponding external universe of securities. Doing this years after years without a slip up is not easy.

Potentially, a Ponzi schemer can use software to produce “error-free” statements. But that would require hiring excellent software programmers. Many reports indicate that the employees working in the Madoff Ponzi scheme were uneducated workers and most likely did not have expertise in investment or software engineering. It appears to me that the numbers for the statements were created manually. With thousands of accounts, faking trade data for each one manually would be an all but impossible task. My guess is that they created a small number of statements and produced the rest by making adjustments. Hence some trades had prices that were out of range.

So running a Ponzi scheme is not as easy as one might think. Just in the several red flags described here, the Madoff statements left many clues that would lead serious investigators to a conclusion of fraud or probable fraud.

With so many red flags in BLMIS account statements, due diligence is not as hard as one might think. Even some basic checks can uncover issues. Checking the trade data on options requires some knowledge and experience with options. For checking stocks, it could be as simple as checking stock prices on Yahoo! Finance. For someone not doing investment for a living, I can understand that he/she may not be inclined to look at the numbers closely. However, there is no excuse for investment professionals and fund managers.

Even individual investors have options too when it comes to vetting and checking investment options and fund managers. There are companies that perform due diligence. There are many professionals and due diligence firms in the investment community who were skeptical of Madoff. Love of Madoff was far from universal!

Robert Rosenkranz of Acorn Partners, an investment adviser for high net-worth individuals, conducted due diligence and found that BLMIS statements indicated likely fraud. The audit included a review of BLMIS customer statements as well as BLMIS statements filed with the SEC.

Simon Ruddick, the managing director of Albourne Partners, a London due diligence firm, has been advising clients to avoid BLMIS for almost a decade. A Fort Worth pension took that advise from Albourne and terminated its BLMIS account in July 2008.

Simon Fludgate, head of operational due diligence at Aksia which is an independent hedge fund research and advisory firm, was looking at Madoff from the angle of trade volume. He found that the stock holdings reported in BLMIS quarterly filings with the SEC were too small to support the size of the assets BLMIS claimed to be managing. As a result, Aksia had advised its clients in 2007 against investing in BLMIS.

All the big guns of Wall Street such as Goldman Sachs, CitiGroup, Morgan Stanley, Merrill Lynch and Credit Suisse, all flatly refused to do business with BLMIS after performing reasonable due diligence.

It will take years to unravel the Madoff web of deceit. The investment lesson will continue to unfold as we know more. So far the Madoff story makes me even more determined to stick with one investment maxim that I hear so often – don’t put all your eggs in one basket.

Any comment?

June 14, 2009

Will The Proposed SEC Surprise Exam Rule Catch Thieves Like Madoff?


Bernie's mug shot

Bernie's mug shot


The Security Exchange Commission (SEC)  is proposing tougher rules to hold investment advisers more accountable for their clients’ funds and assets (the press release was announced on May 14). These proposed rules are amendments to the custody rule under the Investment Advisers Act of 1940 and are aimed at restoring investor’s confidence after the $65 billion Ponzi scheme of Bernard L. Madoff came to light in December of last year.

Typically, registered investment advisors do not have physical control of the clients’ funds and securities under management. Instead the clients’ assets are maintained and controlled by qualified custodians (e.g. banks, registered broker-dealers, and registered futures commission merchants). For a small number of registered investment advisers,  physical control of the clients’ assets rests with the investment adviser or a related person. In either case, the investment advisers are considered to have custody of the assets since they have the authority to deduct advisory fees or withdraw funds on clients’ behalf.

According to the proposed rules, any registered investment adviser who has custody of clients’ funds and securities will face an annual surprise exam by an independent public accountant to make sure that the clients’ assets exist. Furthermore, any investment adviser who has physical control of the clients’ assets must have the internal control of the assets reviewed by an independent public accountant.

In a nutshell, these proposals seek to ensure that the investment adviser will not try to reach his/her hand into the client’s “cookie jar”.

Madoff’s firm, Bernard L. Madoff Investment Securities (BLMIS), both acted a broker-dealer and investment adviser. The broker-dealer side of the company purportedly physically held the clients’ funds and securities. Were the newly proposed SEC rules in place, BLMIS would have been subject to a surprise annual exam on verifying the assets as well as a third party review of the internal control on the clients’ assets. Surely, that would have been enough to flush out Madoff as a fraud long ago. Is it that simple?

Interestingly, these proposed rules are old medicine. Similar rules for surprise exam and controls had been in place at the SEC since 1962. In 2003, the rules were amended to eliminate the annual surprise examination for registered investment advisers for which the qualified custodians of the assets provide statements directly to clients. The thinking at the time was that if the qualified custodian (e.g. a broker-dealer holding the assets on behalf of the clients and the investment adviser) says the securities and cash are still in the “cookie jar”, things must be OK. In light of Madoff and other uncovered Ponzi schemers, SEC now thinks that this was not such a good idea.

SEC is seeking comments from the public through July 28. Here’s my observations.

The proposed rules and the prior rules only apply to investment advisers who are registered with SEC as investment advisers. BLMIS was registered with SEC as a broker-dealer. But for most of its existence, BLMIS was not registered as an investment adviser! So the surprise exam rule to examine clients’ assets would not apply to Madoff before 2003 or after 2003!

It seems that SEC should also address some fundamental questions. How was it possible that Madoff was able to operate under the radar for so long? How was it possible that with billions of dollars under management and thousands of customer accounts, Madoff was able to operate as an unregistered investment adviser? If an investment adviser services 15 or more clients, it is supposed to register with the SEC as an investment adviser. Madoff, as an investment adviser, had thousands of client accounts many years ago. Why was SEC not enforcing its rules on the book?

Even when Madoff filed the application for investment adviser in 2008, he vastly under reported the assets and the number of customer accounts. When Madoff filed the Uniform Application for Investment Adviser Registration in January 2008, he reported that there were 23 customer accounts and $1.71 billion under management. In reality, there were about 4,900 accounts and $68 billion under management. Basically SEC was just taking Madoff at his words. Why was the material facts of the application not verified by SEC?

Though the proposed rules are definitely one step in the right direction, these and a whole host of other questions tell me that the failure of SEC in catching Madoff is not going to be addressed just by reinstating some old rule about surprise exam. If SEC is serious about restoring investor confidence, reform has to be more than window dressing.

SEC had numerous opportunities to catch Madoff but it failed to keep pursuing. It seems to me that before undertaking any serious reform effort, SEC should exam its troubled history with Bernie Madoff.

Any comments?

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