How Bernie Madoff With the Money
Kurt Brouwer December 29th, 2008
My apologies for the play on words in the title. Just could not help myself.
By all accounts, the Madoff scandal was a fraud of epic proportions and a betrayal of those who entrusted their assets to him. If you have somehow missed out on the details of this $50 billion fraud, see Wall Street Journal — Madoff.
My reason for posting on this is quite simple. I have noticed a lack of clarity as to why — or more importantly — how it could have happened.
From what I have read, this investment fraud was made possible chiefly because investors with Madoff did not have an independent custodian for the assets entrusted to his firm. If there had been an independent custodian, I think the scheme would never have been possible. For example, it appears that Madoff did not make the trades in clients accounts that he claimed to have made. If those clients had an independent custodian, they would have seen their account holdings and transactions on the statement. If Madoff claimed to have made a given trade, but it never hit the client’s acount, a serious red flag would have been raised. Also, the returns he claimed were exaggerated. If clients were receiving accurate statements from the custodian, they would have known his performance claims were false.
Yes, investors could have dug deeper and questioned him further, but, in my opinion, the scheme was possible only because the Madoff firm was a brokerage firm that created its own client statements. In short, there was no independent verification that those reports were accurate. The Madoff scheme illustrates what can happen if you lack one of the very important checks and balances that are part of a sound investment structure.
Like many registered investment advisory firms, our firm, Brouwer & Janachowski, LLC, does not hold clients assets directly. Instead, clients have their assets in an account at an independent custodian that provides clients with statements showing the value of their assets, the number of positions held and so on. This type of independent verification of your account status is critical. We direct the investments in those accounts, but the positions held as well as the value of those investments are clearly shown in the statements from the custodian.
A second layer of protection exists for those who, like us, invest primarily in mutual funds because independent reporting on fund results is built by law into the mutual fund structure.
This piece from Brett Arends’ excellent ROI column in the Wall Street Journal makes the point that mutual funds are looking pretty good these days compared to the disaster experienced by the seemingly-sophisticated investors in the Madoff scheme. He lists 10 points from which I excerpted those I thought were most critical [emphasis added]:
Madoff: a Walking Ad for Mutual Funds (Wall Street Journal, December 16, 2008, Brett Arends)
A multibillion-dollar Ponzi scheme reinforces classic investment advice: If it sounds too good to be true, it probably is.
Bernard Madoff has done the impossible: He’s made the rest of Wall Street look good this year.
OK, so your funds lost 40% or more. Mr. Madoff’s clients, from charities to the super-rich, lost the whole salami.
Call it another reason to steer clear of so-called financial wizards and miracle investment funds. Here are 10 reasons why you’re better off opening an online account and investing in ordinary mutual funds - like anyone else.
1. You’ll always know where your money is, and you can get it out at any time…
2. You always know how you’re doing, too. Performance figures are updated daily…
4. Everything is out in the open. Mutual funds have to publish regular updates, telling you what they’ve been doing and why. Mr. Madoff actually kicked people out his fund if they asked too many questions…
Lucky people. Can you imagine how relieved you would be to have been one of those folks Madoff kicked out?
7. You can still get all the diversification you want. Though regular mutual funds you can invest in hedge-fund like “market neutral’ funds, managed timber, Asian real estate, precious metals, and option-selling income funds. You can keep your money in inflation-protected government bonds or Japanese yen. Exactly how much more diversification did you really need?
This is an important point that is often overlooked. Mutual funds cover a very broad array of investment opportunities, from stocks and bonds to gold, energy and many other asset classes.
9. And when you keep your money in public funds you won’t wake up one morning, switch on the news, and discover it’s all gone. The worst one-day loss in history for investors who entrusted their money to the U.S. public markets is about 20%. It happened just once, October 19, 1987 - and they got their money back in due course.
10. And if you really need to brag about your money at the country club, an $8 online trade and a $3,300 stake can get you one share in Berkshire Hathaway. Then you can smugly say, “I have my money with Warren Buffett.” Do you really believe your brother in law’s “financial whiz” is any better?
If you want to share in Buffett’s professional work, you can buy stock in his company, Berkshire Hathaway, which has some similarities to a closed-end mutual fund. Or, you can buy shares in mutual funds that own sizeable stakes in Berkshire Hathaway. The best-known of these funds is Sequoia Fund, which recently re-opened to investors (see Sequoia Fund To Open Up Again).
Obviously, most mutual funds have taken a hit this year. However, they have avoided scandals like the Madoff mess because of the checks and balances inherent to the mutual fund structure itself. This chart and text give you a sense of how funds work. It is excerpted from the Investment Company Factbook, which is created each year by the Investment Company Institute:
Source: Investment Company Institute
As you can see, mutual funds have an explicit structure with checks and balances including an independent audit by a public accounting firm. Investors in mutual funds typically focus on the fund’s portfolio manager and the types of returns the fund has gotten. It is only in times such as these that other aspects of the mutual fund structure come into focus. Those are illustrated in the chart above and in this text from the Factbook about the relatively unsung roles of the custodian and the transfer agent:
Custodians
Mutual funds are required by law to protect their portfolio securities by placing them with a custodian. Nearly all mutual funds use banks as their custodians. The SEC requires any bank acting as a mutual fund custodian to comply with various regulatory requirements designed to protect the fund’s assets, including provisions requiring the bank to segregate mutual fund portfolio securities from other bank assets.
Transfer Agents
Mutual funds and their shareholders also rely on the services of transfer agents to maintain records of shareholder accounts, calculate and distribute dividends and capital gains, and prepare and mail shareholder account statements, federal income tax information, and other shareholder notices. Some transfer agents also prepare and mail statements confirming shareholder transactions and account balances, and maintain customer service departments, including call centers, to respond to shareholder inquiries.
Here are several points I have made over the years. They illustrate precisely why mutual funds are so unique in the wild and woolly world of investing.
Mutual Funds Are A Unique Investment Vehicle
Mutual funds offer a package of advantages available nowhere else:
• Low minimum investment
• Immediate diversification
• Professional management
• Security
• Liquidity
• Audited track records
The first modern mutual fund was the Massachusetts Investors Trust, which came along in 1924, but it took years of trial and error, and a lot of misery before the mutual fund industry, as a whole, adopted the structure and safeguards we take for granted today.The shocking stock market crash of 1929 sparked the Great Depression of the 1930s–10 years of poverty, disillusionment and despair for many. Yet out of that disastrous decade came many reforms (such as the Securities Act of 1933, the Glass-Steagal Act of 1933 and the Fair Labor Standards Act) and the creation of many governmental oversight agencies (the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission, the National Labor Relations Board (NRLB), and the Federal Communications Commission, to name a few). For mutual fund investors, the watershed event was the passage by Congress of The Investment Company Act of 1940, which created the mutual fund structure as we know it today.
Mutual Funds & The Integrated Circuit?
By way of comparison, let’s travel back in time to California in 1959. In case you’ve forgotten, that was when Jack Kilby and Robert Noyce created the first integrated circuit, a single chip of silicon that replaced thousands of transistors and other electrical components and ushered in an era of unprecedented innovation as computer technology became cheaper and more powerful, year after year. From being the exclusive province of governments and well-funded university research laboratories, computer technology is now so pervasive and so inexpensive that we cannot imagine a world without it.
Just as the integrated circuit (the forebear to what we now call the semiconductor) brought computing power to people everywhere, the creation of the modern mutual fund structure changed the nature of financial services and opened up sophisticated investments to investors of all types. One piece of legislation created a new era for investors by setting up the safeguards and structure that enabled mutual funds to become the dominant investment vehicle they are today. This was a relatively simple innovation that did not receive much notice at the time. Yet, it opened up a myriad of possibilities and brought professional management, diversification, safety and other tangible benefits into the hands of all investors, no matter how much money or how little money they have.
Today, there are more mutual funds than stocks on the New York Stock Exchange. New funds open daily, offering a dazzling and sometimes intimidating array of choices. The competition for your money is so intense, that new innovations, marketing approaches, investment styles and services are being announced daily. The smartest people on Wall Street are eager and willing to work for you, for a nominal annual fee. In all of human history, there has never been a time like this.
The ‘40 Investment Company Act — History’s Most Effective Regulation
So, we can thank the far-sighted legislators who created the modern mutual fund more than 60 years ago when they passed the Investment Company Act of 1940. That legislation has given us a golden era for investors that was previously unavailable to all but the very rich. And, as we have seen with the Madoff mess, even the rich would have been better off using mutual funds. Those who did avoided all these problems (Hedge Fund Troubles Take Tragic Turn).
But, even if you do not invest in mutual funds, there is an important safety feature that mutual funds pioneered — the independent custodian. If you invest in investment partnerships, hedge funds and other private investments, you can avoid the heartbreak now being felt by those who invested with Madoff — just make sure there is an independent custodian that holds your assets and reports to you as to the value of those assets.
If you take that simple step, you won’t ever have to wonder if someone is about to make off with your money.
Via: Rita Lee
- Hedge Funds , Investing , Money , Mutual Funds , Personal Finance
- Comments(10)
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An intriguing finding: It appears that even Mr Madoff’s golf scores were too consistently good.
http://www.google.com/search?hl=en&ie=ISO-8859-1&q=madoff+golf&btnG=Google+Search
The guy’s ego couldnt tolerate even the humbling discipline of honestly recording fluctuations in his own performance at golf.
The Victorians may have been wiser than we give them credit for when they linked sports with character.
(quote)Mr. Madoff actually kicked people out his fund if they asked too many questions…(unquote)
This resembles how personality cults operate. Am not kidding. For a hobby, I study such groups.
One trick used by some scamster gurus or cult leaders is at times to refuse donations, saying that the donor ‘isnt ready yet’ or doesnt meet some mysterious standard set by the cult leader.
This makes it seem a rare honor to give the person money. Later, the scamster guru may allow the eager donor give an even *larger* sum of money then before!
In one news article a comment was made that investors must beware of what are termed ‘affinity networks’ and Mr Madoff functioned within such a context, making it seem a rare honor and a source of prestige to invest with him.
The same reporter quoted someone as saying that all too often similar such scams are floated via trust basted networks such as church congregations, situations where one feels shameful even to have doubts about such a person, a situation where one thinks of it as ‘family.’
December Baker
I think the Madoff scandal will resonate for decades within those groups that were affected most. Certainly, misplaced trust was an issue, but I suspect the guy knew how to play on people as you suggested. People thought he had magic so they did not want to rock the boat by asking too many questions. Trust, but verify is still a solid rule to follow.
(No need for further comment by Kurt who has been working hard to take care of all of us)
‘Trust but verify’–this seems like such an obvious thing to do.
The problem is that we humans are social animals and this is both our glory and our danger.
There are persons who know how to forge emotional bonds with us long, long before the question of money and investment even comes up.
When that emotional bond is forged, and it is often forged with the utmost finesse, fact checking becomes then becomes unthinkable.
Or the mere thought of doing a background check makes a person feel shitty for even imagining it.
Someone needs to do a study on folie a deux or codependence within investment and business relations.
Again, some of these set ups seem similar to personality cults. The passion of belief makes persons like Bernie Madoff seem more like cult gurus than businessmen.
So that is the thing to explore–what it is about some persons and certain kinds of social networking that lead us to go unconscious, regress and not fact check?
For fact checking is done at the adult cognitive level. When someone get get us to regress to a more childlike cognitive and emotional state, we cannot access the skills and awareness needed to remember there is such a thing as fact checking.
They have identified factors that cause psychotherapists to be at risk of committing boundary violations with clients.
The working alliance between therapist and counselee takes place within a boundaried relationship–aka ‘the container.’ This allows the client to regress safetly and then regain autonomy at the end of the 50 minute hour and resume normal adult function after leaving the session.
It might be necessary for financial advisors to learn from Madoff by giving attention to boundary issues–it might be a good subject to add to business school curricula.
For after a lot of messy situations, psychotherapists have learned that what are termed ‘dual relationships’–are an important risk factor for boundary blurring and therapist malfeasance.
Examples of dual relationships are becoming friends with clients outside of the consulting room, or a therapist getting into business a relationship with a clients, or worse yet, having an intimate relationship with a client.
This kind of boundary blurring creates such high risk of provider malfeasance that some dual relationships between therapists and clients are forbidden by law, or are at least frowned upon by wise colleagues.
Therapists who are heedless of boundaries and who deny the actual power imbalance between themselves and clients, are the ones most apt to get into trouble.
It may be that Mr Madoff had a history of seeking out dual relationships and that he was unwilling to see himself as a fiduciary accountable to an ethos of care. This attitude requires a stable adult ego—very difficult for someone so ego involved that he reportedly did not even record his own golfing performance in a realistic manner.
One might identify similar risk factors amongst investment relations that go sour.
Just muttering to myself. This is an area that is wide open for future researchers.
We would need an interdisciplinary approach between research psychologists and financial experts.
C
DB — Obviously, you know a lot about this topic. And, the relationship between a financial advisor and client could be analogous to that of a therapist and client. I had never thought of it that way before.
I’m sure we will learn much more about Madoff’s ability to garner trust in years to come. He obviously had lots of charisma. I imagine the first book about him will be out early next summer and we will learn much, much more.
An article from the NY Times Sunday Business section by Ben Stein
entitled, “They Told Me that Madoff Never Lost Money”
http://www.nytimes.com/2008/12/28/business/28every.html?em
(quote)By BEN STEIN
Published: December 26, 2008
ABOUT two years ago, a little delegation from a major investment bank arrived at my home in Beverly Hills. These nice young people were from the bank’s “wealth management division.” I told them straight away that I didn’t have anywhere near enough wealth to make their trip worth their time, but they smilingly insisted that we could help each other….(unquote)
Who were the ‘nice young people’ in this little delegation?
Is it even kosher for investment professionals to send outreach teams, unsolicited, to someone’s home, as Mr Stein describes?
This sounds yet more like the behavior of a cult rather than a professional investment firm.
(It would be especially good to get the names of these nice young people so that we can get ‘em into a room one by one, and depose them. How were they selected for this job? Who selected them? Who trained them? Who provided the room and training materials? Inquiring minds need to know.
Also…how did they select their targets? How is it that Mr Stein was selected and not other people? Were the nice young people working door to door, or did they work from membership lists from country clubs? Did any of them work for a bank, covertly list clients who had large accounts and then pass that information on to Madoff? We need to identify them and subpoena them and depose them. DB)
Mr Stein’s entire article is worth reading. He makes this choice comment:
“By the same token, I belong to a number of country and town clubs. In all of my years at them, I have never gotten an investing tip that made money. In fact, as far as I can recall, I have never gotten a tip from any source that made me money, except for my former agent’s wife mentioning Berkshire Hathaway, Mr. Buffett’s company, 30 years ago.”
Additional commentary on Mr Stein’s article is available here:
http://www.google.com/search?hl=en&ie=ISO-8859-1&as_q=madoff+genius&as_epq=ben+stein&as_oq=&as_eq=&num=10&lr=&as_filetype=&ft=i&as_sitesearch=&as_qdr=all&as_rights=&as_occt=any&cr=&as_nlo=&as_nhi=&safe=images
[…] Kurt at FundMastery strengthens a point I made two weeks ago (”Don’t have all of your money with one adviser, especially a long ranger who has control over generating account statements”) about why Bernard Madoff was able to make off with so much investor dough (my bold) — “….. the scheme was possible only because the Madoff firm was a brokerage firm that created its own client statements.” He also has a pic of the kind of org chart with the control structure and separation of duties required to prevent, absent massive collusion that could almost never be sustained, an institutional version of what Madoff did. […]
This isnt quite about Bernie Madoff (why isnt the fellow in a jail cell by now–or at least in some form of highly supervised custody, with no access to postal facilities, family jewelry, etc??)
Fallen Lehman Brothers Chief Executive Richard Fuld reportedly sold his $13.3 million mansion to his wife for just $100 last November.
Whether this falls within the rules of evidence as being nothing more than a perfectly normal real estate transaction remains to be seen.
See Google search results here,as of January 29:
http://www.google.com/search?hl=en&ie=ISO-8859-1&q=fuld+lehman+mansion&btnG=Google+Search
One of the San Mateo County (California) Supervisors had something to say about it.
http://www.mercurynews.com/peninsula/ci_11570728
DB — The transaction by Lehman’s former leader to sell a $13 million Florida estate to his wife for $100 was an attempt to shield his assets from lawsuits I believe. Florida has an interesting homestead provision in that a home — of any value — is exempt from legal judgements. Other Wall Street financiers have used this provision to shield assets.
The hardy pioneers who originally benefitted from the homestead laws in Florida and elsewhere would probably be amazed to see who is benefitting from those same laws today.
(Heavy sigh)
Yet to safeguard the laws and constitution of the United States of America, laws meant to protect ordinary people, those same resources provided by law have to be made available to persons we dislike.
Thats part of what led so many to take a chance homesteading, and, in Florida, doing it despite hurricanes, malaria, and yellow fever.
Hahaha — Kurt, no apology necessary…great title!