Friday, August 26, 2016

Friday BookReview: Bernie Madoff and the snoring watchdog

When the SEC was formed in 1934, who was its chairman?
Joseph Kennedy, father of America's 35th president.

"The government agency charged with being the industry's watchdog was deaf, blind, and mute... I realized that I had two opponents, Bernie Madoff and this nonfunctioning agency that seemed to me to be doing everything possible to insulate him."  (Harry Markopolos)

A short and sweet primer on the completely ineffectual Securities and Exchange Commission. In the end, the world started listening to Harry Markopolos.

This segment from '60 Minutes' on the fraud investigator from Boston fleshes out his efforts to expose the crimes of Mr. Madoff. (Now imprisoned in North Carolina, the one-time chairman of the NASDAQ told a reporter on the phone: "I'm not a horrible person." Madoff chooses to ignore the thousands of lives he destroyed, including his own family).

A review of Mr. Markopolos' book which appeared in an actuarial magazine:
Readers of 'The Actuary' may remember a well-known fund manager disparaging the role of actuaries in investment matters... A few months later, her fund shared in the $65 billion loss when Bernie Madoff’s Ponzi scheme collapsed. 
Harry Markopolos studied Madoff’s strategy and investment performance, establishing a decade before its collapse that the two did not tie up. Over several years, Markopolos painstakingly documented a long list of red flags, each of which raised a suspicion of fraud. For example, the strategy should produce far more losses than it did. Returns should have been correlated to the stock market, but they weren’t. Given the funds Madoff had under management and the claimed strategy, the number of options he’d have to buy and sell would be huge — in fact, more than the open interest for the whole market on the options exchanges. Yet, there was no trace of Madoff’s deal flow either on the exchanges or in the over-the-counter market. Furthermore, Madoff organised his business in some very odd ways. Although effectively operating as a hedge fund, his organisation was constituted as an agent running trading strategies for his clients. 
His auditor was a sole trader a few blocks down, who apparently had no other audit clients. All the stock and option positions disappeared each year-end, and the financial statements showed only treasury bills. Madoff wouldn’t let anyone else near the books, even accountants acting for investors seeking to carry out due diligence before placing funds. Madoff was offering substantial commissions to feeder funds, providing high and stable returns. Why pay these costs when bank loans would be far cheaper? And then there’s all the secrecy. Investors widely believed that their ability to invest in these funds was a personal favour from Bernie Madoff, and were forbidden to discuss their good fortune with anyone else. This list of red flags formed the basis of Markopolos’ regular correspondence with the Securities and Exchange Commission. 
Markopolos also discovered why investors continued to invest with Madoff despite the red flags being common knowledge. Madoff ran a large and well- known brokerage. Could he be ‘front running’; that is, buying on his own account ahead of brokerage client buy orders, watching the market price rise and then selling onto those brokerage clients at a higher price? Front running is a form of insider dealing, which robs brokerage clients in favour of investors. Markopolos reckons that Madoff’s investors knew they were benefiting from something illegal, hence the willingness to invest in the absence of due diligence. The critical calculation concerns whether you keep your gains when the crime comes to light. The answer: probably yes if it’s insider dealing, but no if it’s a Ponzi scheme. 
The scheme finally collapsed when Madoff simply turned himself in, after 20 years of trading unmolested by the SEC. Unlike many financial professionals, Markopolos has nothing more to lose from irritating the SEC, which he exploits mercilessly in an outpouring of vitriol that is both shocking and refreshing. A theme of ‘I told you so’ rises in a gentle crescendo as the book progresses. In the end, Markopolos positively revels in the discomfort of senior SEC employees as they struggle to defend their jobs. This smugness has to be balanced by Markopolos’ constant fear for himself and his family. In his whistleblowing days, Markopolos fears retribution from mafiosi types who may blame him for bringing Madoff down. Later, he fears dirty tricks from the SEC as they rush to suppress evidence while scrambling to paint Markopolos as a deranged fantasist whom they were justified in ignoring. 
This was easily the most exciting book I have read this year. The audacity of the fraudster, the complicity of the investment community, the incompetence of the regulator — all are laid bare. But this book is more than a profoundly impressive technical account of a fraudulent investment scheme, more than a keen analysis of regulatory failure. At heart, it is a very human account of lonely life as a whistleblower, with the discouraging conclusion that, most of the time, nobody listens. 

The Great Depression of 1929 was worldwide, and lasted a decade.

In 2006, housing prices began to fall. When the housing bubble burst, the Great Recession was upon us. It lasted from December 2007 to June 2009.

The "subprime mortgage crisis" was caused by banks lending hundreds of billions of dollars to homebuyers, who then were unable to pay them back.

Sept 2008: Lehman Brothers declares bankruptcy -- the largest such filing in US history
(Lehman was the fourth biggest investment bank in the country)

Nov 2008: Senator Obama is elected president

Dec 2008: Bernie Madoff is arrested by the FBI

Here are some of Mr. Madoff's comments regarding the SEC.

(In that article, mention is made of Madoff's niece, Shana, and her marriage to a SEC attorney. More can be found here.)
Shana Madoff and husband Eric Swanson

"For three-quarters of a century, the SEC was aggressive, waging high-profile investigations against insider trading, corporate bribery, and fraud... In the last few decades of the twentieth century, however, the SEC had begun filling its ranks with lawyers instead of traders, analysts, bankers, or other people with Wall Street experience. The SEC was established for the sole purpose of regulating the financial industry, yet it was hiring people with no financial background."                                                        (Erin Arvedlund, author of a book on Bernie Madoff) 

UPDATE -- Here is an excerpt from the 'primer' interview with Mr. Markopolos mentioned above:

Why do you think the S.E.C. failed to wake up to Madoff’s $65 billion Ponzi scheme until he turned himself in?
They weren’t even asleep at the switch; they were comatose. They didn’t respond to heat and light, much less evidence of wrongdoing. They were not engaged in the fight.

Mr. Donaldson -- chairman 2003-2005

This was when William Donaldson was head of the S.E.C.? 
Donaldson was too tough on Wall Street, so he got the ax. Then you had Christopher Cox, because he wasn’t going to do his job. That’s why he got the job.

Mr. Cox -- chairman 2005-2009
(had been longtime California congressman)

You met last year with Mary Schapiro, the current head of the S.E.C. How did that go? 
I would say she was coldly polite. Her general counsel, David Becker, did most of the talking. He and I did not get along at all. He was getting ready to come across the coffee table and strangle me.


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