The Hindu Business Line : He Made off with their money

The Madoff scam will hopefully lead to some re-think and re-write of the regulatory rules, especially on the separation of front and back offices, and audit.

J. Srinivasan

From Spanish bank, Santander, to film-maker, Steven Spielberg, institutions and individuals are shamefacedly acknowledging being part of Bernard Madoff’s Ponzi scheme in which hedge funds worldwide have lost another $50 billion. The Madoff scandal broke on December 11, after the Wall Street operator was arrested and later put under house-arrest. Madoff, according to prosecutors, admitted to his advisory fund using the money from new investors to pay profits to existing investors.

Taking away the gloss

The Madoff scandal is at once an indictment of the Securities and Exchange Commission as of the poor due diligence by the hedge funds. Indeed, many guilty of the latter — the most famous being UK’s superwoman Nicola Horlick, whose Bramdean Asset Management with some 8.5 per cent allocation, could be facing serious losses — are crying hoarse about the former. This is ironical because lax regulatory oversight in the first place helped many a fund of fund make money short-selling shares. In fact, according to a Financial Times report, as recently as May, Horlick had said that Bernard Madoff was “very, very good at calling the US equity market.”

As can be expected, the Madoff scam took away the little of the gloss that remained on hedge funds. All London-listed funds, regardless of whether or not they were invested with Madoff, were marked lower. Already trading at massive discounts to their net asset value, the scandal could worsen the situation. But they are just paying the price for going short on due diligence lured by the unrealistic “steady, market-beating returns” of Madoff-type operators that enable them to charge the stiff, standard 20 per cent fee.

Luring investors

The question that rankles is how could Madoff swindle so many so called ‘smart investors’, including institutions, for so long? The scam, according to prosecutors, could have begun in 2005 though the top market-maker on Nasdaq opened an investment firm almost a decade ago. Like the spider, Madoff is thought to have used his standing in his Jewish community and connections in New York and Palm Beach, Florida, to lure investors to his Ponzi web.

To describe this set, Financial Times quotes Patrick Columbia, editor of NewYorkSocialDiary.com: “This is a community of affluent Jewish people who basically socialise with each other. They are philanthropic and all support each other’s charities. Even though Mr Madoff was not a top member of this community, his business made him the man to know. He became an icon of financial success for them.”

The dilemma is should the people, who were getting steady, solid returns, be blamed for their greed? Or, is it the regulator who is guilty? For, why should an investor not aspire for solid, steady returns as long as he invests with a fund in good faith? And if a person remains on Wall Street (or its equivalent anywhere) it is only fair to assume that the market regulators know of the person and his operations. Further, Madoff had chaired Nasdaq for a few years.

This is why Madoff, who regularly beat other fund managers and the market, drew to him ever more investors, recommended by friends, from the US and Europe.

When the bubble burst

These investors, who were mainly just adding a couple of more zeros to their already long strings, did not ask too many questions because they were getting their profits. Madoff was a Wall Street veteran and could be expected to know the ropes better than most. So the profits and the bubble grew. Only to burst in the first week of December, when Madoff could not meet redemption requests for $7 billion.

If anyone is to blame, then it is the lax regulation. Unfortunately, much of the Western press is blaming investors’ constant hunt for high returns, calling it fool’s gold, that is lured by the Street insiders. At least the SEC chief, Christopher Cox, had the courage to accept blame for not detecting the Madoff scam despite credible suspicions being brought to the agency on numerous occasions about the operations.

But this is being dismissed as an attempt by Cox to deflect blame from himself. Hopefully, the internal inquiry that Cox has ordered will throw more light on the hows and whys of the scam.

Light-touch regulation

The Madoff scam is very like the last nail on the SEC coffin. Its reputation has taken a severe beating in the last year when it failed to notice the problems with Bear Stearns and then Lehman Brothers, both of which collapsed. The latter set off the financial crisis that is threatening to draw the world into a prolonged slowdown.

In its defence, the SEC claims shortage of resources to monitor an exploding investment advisory industry. But more than this to blame is its light-touch regulation that gives virtually a free hand to most market operators.

Naturally, SEC has attracted widespread criticisms from both sides of Atlantic, especially by funds, advisers and investors who rejected the Madoff investment. They think the whole affair bristled with red flags for the SEC or the funds and investment advisers to miss.

The real problem

So the real problem is not so much with people’s greed. Capitalism says nothing about limiting market participants’ greed perhaps realising that only then will people take risks and invest.

Capitalism also couches it better, saying high-risk-high-reward. But certainly one of capitalism’s key principles is effective regulation. Only the neo-conservative economics practised in the US over the last decade wants the government out of everything.

Thus, the string of scams. Thanks to this policy approach, every scam leaves the regulators blunter rather than sharper and smarter. Else, how could the SEC, with all the sophisticated systems and surveillance facilities, have fallen for one of the oldest con — a Ponzi scheme of 1900 vintage?

The Madoff scam will hopefully lead to some re-think and re-write of the regulatory rules, especially on the separation of front and back offices, and audit. Some blame-game will happen and heads may roll. Good, if that will tighten up the lax regulatory system.

( blfeedback@thehindu.co.in)

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