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Madoff Madness Exposes Rampant Fraud and Corruption

Stock-Markets / Scams Dec 15, 2008 - 12:00 PM GMT

By: Mike_Shedlock

Stock-Markets Best Financial Markets Analysis ArticleCorruption, fraud, and greed are rampant in every bull market. When the bear strikes that corruption and fraud are exposed.

The biggest fraud in history was perpetrated Bernard Madoff, former chairman of the Nasdaq stock exchange. Many knew he was a crook as explained in Madoff Madness: "I knew he was cheating, That's why I used him" .

The fallout from the fraud continues. Let's take a look at some headlines.

Two Banks Exposed To $50 Billion Con

Two major European banks said they have exposure worth billions of dollars to a US broker accused of a $50bn (£33bn) Wall Street fraud scheme. Spain's largest bank, Santander, which also owns three UK banks, said one of its funds had $3.1bn invested in the firm run by Bernard Madoff.France's BNP Paribas estimated its exposure to be more than $460m.

Mr Madoff has been charged with fraud, in what is being described as one of the biggest-ever such cases. Correspondents say the case is likely to fuel uncertainty about the entire hedge fund industry.

Big investors may lose in alleged $50B fraud

From a Jewish youth charity in Boston to major banks as far afield as Zurich, the list of investors who say they were duped in one of Wall Street's biggest Ponzi schemes is growing.

One thing was clear in the fallout from his arrest: The alleged victims span from the super rich, to pensioners and powerful financial institutions, to local charities. Some investors claim they've been wiped out, while others are still likely to come forward.

In Boston, the Robert I. Lappin Charitable Foundation, a charity that financed trips for Jewish youth to Israel, said on its Web site Sunday that the money for its operations was invested with Madoff.

New Jersey Sen. Frank Lautenberg, one of the wealthiest members of the Senate, entrusted his family's charitable foundation to Madoff. Lautenberg's attorney, Michael Griffinger, said they weren't yet sure the extent of the foundation's losses, but that the bulk of its investments had been handled by Madoff.

Reports from Florida to Minnesota included profiles of ordinary investors who gave Madoff their money. Some had been friends with him for decades, others were able to invest because they were a friend of a friend. They told stories of losing everything from $40,000 to an entire nest egg worth well over $1 million.

They join a list of more powerful investors that have come forward, all worried about the extent of their losses. The roster of names include Philadelphia Eagles owner Norman Braman, New York Mets owner Fred Wilpon and J. Ezra Merkin, the chairman of GMAC Financial Services, among others.

Japan's largest brokerage, Nomura Holdings, said Monday it has about $306 million, in exposure to the Ponzi scheme.

Noel's Fairfield Sent Madoff $7.3 Billion as Funds Earned Fees

Walter Noel's Fairfield Greenwich Group would have collected about $135 million in fees this year for peddling Bernard Madoff's investing acumen to clients from South America, the Middle East and Asia.

The $7.3 billion Fairfield Sentry Fund invested solely with Madoff, taking a cut of 1 percent of assets and 20 percent of gains, which averaged about 11 percent annually in the past 15 years, according to data compiled by Bloomberg. Fairfield Greenwich is one of at least 15 hedge-fund firms and private banks, including Tremont Holdings Group Inc. and Banco Santander SA, that earned similar fees for sending customers' cash to the 70-year-old money manager.

“It's mind-boggling that people like Tremont and Fairfield Greenwich had been doing this for so long,” said Brad Alford, who runs Alpha Capital Management LLC in Atlanta, which helps clients choose hedge funds. “It's the job of these funds of funds to be doing due diligence. That's why they get paid.”

Investors ensnared by Madoff include Fred Wilpon, the owner of the New York Mets baseball team, clients of private bankers in Geneva, wealthy Jewish families in New York and Palm Beach, Florida, and institutions including BNP Paribas SA in Paris that loaned investors money to increase their bets. Losses have been reported by a pension fund in Fairfield, Connecticut, New York hospitals and a charity in Salem, Massachusetts.

While Madoff didn't run a hedge fund, his alleged crime may accelerate investor defections from the $1.5 trillion industry, already hit by its worst losses since at least 1990 and redemptions that may reach $400 billion this year, according to estimates by Morgan Stanley. In a Ponzi scheme, returns to early investors are paid with money from later ones, until there isn't enough cash to go around. Madoff's alleged scam unraveled when he received $7 billion in redemption requests that he couldn't meet.

Fairfield Greenwich is the biggest loser to emerge so far from the Madoff scandal. It had more than half its $14.1 billion in assets with him, according to a company statement.

Madoff Auditor Under Investigation by New York State Prosecutor

The auditor for Bernard L. Madoff Investment Securities LLC, whose namesake was charged in a $50 billion Ponzi scheme last week, is under investigation by the district attorney in New York's Rockland County, a northern suburb of New York City.

The New City, New York, auditing firm Friehling & Horowitz signed off on the annual financial statement of Madoff's Manhattan-based investment advisory business through Oct. 31, 2006, according to a copy obtained by Bloomberg News.

The copy of the four-page annual financial statement, dated Dec. 18, 2006, attested that the financial statements of Madoff's securities firm were “in conformity with accounting principles generally accepted in the United States.”

Hedge fund investment adviser Aksia LLC warned clients last year not to put their money with Madoff after learning of “red flags” at his company, including that its books were audited by a three-person accounting firm.

How Can You Spot A Wall Street Crook?

There's no shortage of cases in which shady hedge-fund managers have disappeared with hundreds of millions of dollars, but the size of what seems to have happened with Madoff is well beyond anything in Wall Street memory.

The question that everybody with big chunks of money parked with exclusive fund managers on Wall Street will be asking today is whether there are other possible Bernard Madoffs out there: high-profile managers who've been lying about their returns for years. The answer to this is going to be "yes," which leads to the second question of, "Is there any way to spot them?" Or, in other words: Is there a way to know whether a money manager's returns are too good to be true?

The key here is not looking just at how well Madoff seemed to perform. It's how consistently he seemed to be doing it. Stories in both the New York Times and the Wall Street Journal both noted the pattern. According to the stories, he seemed to make a return of 10 percent or 11 percent a year, year in and year out. And it wasn't just an annual return kind of thing. Almost every month, the WSJ story says, Madoff made somewhere between 0 percent and 2 percent. Hardly any losses, no really outsize gains.

The key concept here, developed by MIT professor and noted hedge-fund theorist Andrew Lo, is "serial correlation." Simply put, serial correlation is the degree to which each month's returns in a fund mirror the results of the month before. A fund that returns the exact same amount every month is perfectly serially correlated. Madoff's returns were strikingly consistent month after month, year in and year out. That kind of performance—a nice, smooth line going up no matter what the market does—is a really good sign that you should look more closely.

The extraordinary thing that Lo does in the third chapter of his book Hedge Funds, published earlier this year, is to demonstrate mathematically that an excessive degree of serial correlation is a powerful indicator that the holdings of a fund aren't being reported realistically.

What Lo shows from the pattern of historical returns in hedge-fund databases is that when funds' returns grow too consistent, it is a sign that the investments are either very hard to value accurately and the returns are just guesses, or, worse, that they've been manipulated in a way that smoothes them artificially. What Lo creates is a mathematical model for judging what "looks too good to be true."

When things are going well, however, investors rarely want to look at the results too closely. It's only when they ask to take out money that's no longer there that they find out what was going on.

The Madoff story is a bit of an anomaly in that, if what's in the criminal complaint is even close to accurate, he fessed up to what was going on before the government came looking for an indictment. It's early to speculate about what might have motivated him, but it's a fair bet that protecting his sons, who ran the business with him, from prosecution would be high on the list of concerns. Whoever is next probably won't volunteer so much so readily, preferring the more conventional approach of letting the game play out to the bitter end and then denying everything.

You can bet that right now, though, major investors are scrambling to crunch the numbers on other boutique managers. One thing that almost everyone on Wall Street has had drummed into them is that bad news is, in Wall Street lingo, "highly correlated": It tends to come in clusters and bunches. If one investment manager's holdings can go from $17 billion to zero overnight, it's likely there are several more multibillion-dollar blowups just waiting to rear their heads.

Madoff ‘Tragedy' Said to Have Escaped Scrutiny by SEC

U.S. regulators never inspected Bernard Madoff's investment advisory business, alleged to be a Ponzi scheme that cost investors $50 billion, after he subjected it to oversight two years ago, people familiar with the case said.

The Securities and Exchange Commission hadn't examined Madoff's books since he registered the unit with the agency in September 2006, two people said, declining to be identified because the reviews aren't public. The SEC tries to inspect advisers at least every five years and to scrutinize newly registered firms in their first year, former agency officials and securities lawyers said.

“Given what the SEC claims is the magnitude of the fraud, this is something you would hope an inspection would have uncovered,” said Mercer Bullard, a University of Mississippi law professor and former mutual-fund attorney at the SEC. “It's hard to imagine a fraud of this alleged size not being accompanied by significant and pervasive compliance problems.”

The SEC's Office of Compliance Inspections and Examinations deploys teams from Washington and 11 regional offices to scout for fraud and gauge brokerages and investment managers' adherence to securities laws. Its roster of full-time employees peaked at 880 in fiscal 2006, according to agency budget requests. The regulator expects to have 796 full-time workers in its inspections office for the fiscal year ending next September.

More than a decade earlier, in 1992, Madoff faced regulatory scrutiny as part of a lawsuit the SEC brought against two Florida accountants, whom it accused of raising $441 million while selling unregistered securities over three decades, according to SEC statements and a press report at the time.

Madoff told the Wall Street Journal at the time that he had managed the funds unaware they had been raised illegally. The SEC determined that the investors' money was all accounted for, and didn't accuse him of wrongdoing, according to the report.

On the morning of Madoff's arrest, more than a dozen SEC inspectors assembled at his office in Manhattan and have since worked overtime to untangle the mess. Though some investigators initially thought the $50 billion total was too high, they now see it as plausible, people familiar with the matter said. The increasing tally is still below that, one person said.

The Securities Investor Protection Corp., which insures customers' brokerage accounts, plans to take over the brokerage side of Madoff's business as early as today, three people said. The Washington-based SIPC oversees the transfer of client holdings, including cash and securities, when a brokerage fails.

Such a large Ponzi scheme -- in which early investors are paid with money raised from subsequent victims -- should prompt lawmakers to review how the U.S. polices brokerages, wealth managers and unregistered advisers, such as hedge funds, said James Cox, a securities law professor at Duke University in Durham, North Carolina.

“There are just so many people out there who are and aren't registered that it really just overwhelms the system,” Cox said. “There is no easy way to expand the regulatory net unless we're willing to put the might of the federal budget behind it to carry out more inspections.”

Any suspicions about Madoff may have been damped because of his association with industry groups, watchdogs and politicians.

Since 2000, he has given at least $100,000 to the Democratic Senatorial Campaign Committee and more than $23,000 to the party's candidates, including Senator Charles Schumer of New York and Senator Frank Lautenberg of New Jersey, who leads a charitable foundation that invested with Madoff.

Expect More Regulation

One sure bet out of this mess is we are going to see lots more regulation. As I said in my first post on Madoff Madness, " massive regulation and crackdowns on hedge funds are in store for 2009. Those crackdowns will cut the number of funds in half if not more. Unfortunately, even those who run a clean ship will be affected by the cost of the massive regulation that is without a doubt coming. "

By Mike "Mish" Shedlock

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Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at .

© 2008 Mike Shedlock, All Rights Reserved

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