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Frauds of the Century

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{DC(-P[,"^q-' li Frauds of the Century
BERNARD MADOFF worked as a lifeguard to eam enough money to start his own securities

firm. Almost half


century later, the colossal Ponzi scheme into which it mutated has proved

impossible to keep afloat unlike Mr Madoffs 55-foot fishing boat, "Bull,,.
The $ I 7. I billion that Mr Madoff claimed to have under management earlier this year is all but gone. His alleged confession that the fraud could top $50

billion looks increasingly plausible:,


clients have admitted to exposures amounting to more than half that. On December l6th the head

of the Securities Investor Protection Corporation, which is recovering what it can for investors, said the multiple sets of accounts kept by the 70-year-old were in "complete disanay" and could

take six months to sort out. It is hard to imagine a more apt end to Wall Street's worst year in decades. The known

list of victims grows longer and more star-studded by the day. Among them

are prominent billionaires, including Steven Spielberg; the owner of the New York Mets baseball

team; Carl Shapiro, a nonagenarian clothing magnate who may have lost $545m; thousands


wealthy retirees; and a cluster of mostly Jewish charities, some of which face closure. Dozens


supposedly sophisticated financial firms were caughl out too,.including banks such as Santander and HSBC, and Fairfield Greenwich, an alternative-investment specialist that had funnelled no less than $7.5

billion to Mr Madoff.

Though his operation resembled a hedge-fund shop, he was in fact managing client money in brokerage accounts within his firm, seemingly as Merrill Lynch or Smith Barney would. A lot of

this came from funds of funds, which invest in pools of hedge funds, and was channelled to Mr

Madoffvia "feeder funds" with which he had special relationships. Some banks, such as the
Dutch arm of Fortis, lent heavily to funds of funds that wanted to invest.


On the face of it, the attractions were clear. Mr Madoffs pedigree was top-notch: a pioneering

marketmaker, he had chaired NASDAQ, had advised the government on market issues and was a noted philanttuopist. Turning away some investors and telling those he accepted not to talk to outsiders produced a sense of exclusivrry. He generated returns to match: in the vicinity

of 10% a

year, through thick and thin.

Charming, but far too smooth
That last attraction should also have served as a warning; the results were suspiciously smooth.

Mr Madoffbarely ever suffered

a down month, even

in choppy markets (he. was up in

November, as the S&P index tumbled 7.5%). He allegedly has now confessed that this was achieved by creating a pyramid scheme in which existing clients' retums were topped up, as needed, with money from new investors.

He claimed to be employing an investment strategy known as "split-strike conYersion". This is a

fairly common approach that entails buying and selling different sorts of options to reduce volatility. But those who bothered to look closely had doubts. Aksia, an advisory firm, concluded that the S&P 100 options market that Mr Madoff claimed to trade was far too small to handle a

portfolio of his size. It advised its clients not to invest. So did MPI, a quantitative-research firm, after an analysis in 2006 failed to find a legitimate strategy that matched his returns-though they were closely correlated with those of Bayou, a fraudulent hedge fund that had collapsed a year earlier.

This was not the only danger signal. Stock holdings were liquidated every quarter, presumably to avoid reporting big positions. For a godfather of electronic trading, Mr Madoff ran the business along antediluvian lines: clients and feeder-fund managers were denied online


to their

accounts. Even more worryingly, he cleared his own trades, with no external custodian. They

were audited, of course, but by a tiny f,rrm with three employees, one of whom was a secretary and another an 80-year-old based in Florida.
Perhaps the biggest waming sign was the secrecy with which the investment business was conducted. It was a black box, run by a tiny team at a very long arm's length from the gtoup's

much bigger broker-dealer. Clients too were kept in the dark. They seemed not to mind as long as the retums remained strong, accepting that

to ask Bernie to reveal his strategy would be as

crass as demanding to see Coca-Cola's magic formula. Mr Madoff reinforced the message



occasionally ejecting a client who asked awkward questions.
The trading business was hardly pristine either. It had been probed for front-running (trading for its own account before filling client orders) and separately found gullty of technical violations.
Some clients reportedly suspected that Mr Madoff was engaged in wrongdoing, but not the sort

that would endanger their money. They thought he might be trading illegally for their benefit on

information gleaned by his market making arm.
This failure of due diligence by so many funds of funds will deal the industry


blow. They are

paid to screen managers, to pick the best and to diversify clients'holdings-none of which they

did properly in this case. Some investors are understandably irate that their funds-including one run by the chairman of GMAC, a troubled car-loan firm-charged above-average fees, only to

plonk the bulk of their cash in Mr Madoffs lap. This is the last thing hedge funds need, plagued as they are



wave of redemption requests.

Financial firms that dealt with Mr Madoff are bracing themselves for a wave of litigation as

individual victims go after those with deep pockets. Hedge funds will also face pressure to accept further oversight. But the affair shows the need for the government to enforce its rules better, rather than write new ones, argues Robert Van Grover of Seward

& Kissel, a law firm.

Mr Madoffs investment business was overseen by the Securities and Exchange Commission investors (SEC), but it failed to carry out any examinations despite receiving complaints from

Madoff was close to and rivals since as long ago as the late 1990s. As a Wall Street fixtwe, Mr married a former mernber several SEC officials. His niece, the firm's compliance lawyer, even


there is no the team that had inspected the marketmaking division's books in 2003-though evidence of improprietY. of the case
In a rare mea culpa,Christopher Cox, the SEC's chairman, has called its handling
..deeply troubling" and promised an investigation of its "multiple failures". Having already been is now likelier than ever lambasted for fiddling while investment banks bumed, the commission expected under Barack to be restructured, or perhaps even dismantled, in the regulatory overhaul

Mary Schapiro, an obama. As The Economist went to press Mr Obama was expected to name experienced brokerage regulator, to replace Mr Cox'
The rules themselves


need changing, too.

All investment

managers, not

juit mutual funds,

scrutiny, says Larry could now be forced to use external clearing agents to ensure third-party
Harris of the University of Southern Califomia's Marshall School of Business.'Regulation


be done to encourage financial firms' accountants may also need tightening. And more could huge amount of whistle-blowing. Mr Madoff claims to have acted alone. But given the

knew about it' paperwork required to keep his scam going, it seems unlikely that no one else may have been
Above all, however, investors need to help themselves. This pyramid scheme and, as Mr Harris puts unprecedented, but the lessons are old ones: spread your eggs alound


.,investigate your good stories as well as your bad ones." This is particularly true of money

more so.during managers who work deep in the shadows or seem beyond reproach-even

to speculate' There booms, when the temptation to swindle grows along with the propensity


always be "sheep to be shorn", as Charles Kindleberger memorably wrote in "Manias, Panics and Crashes". Let us hope they never again line up in such numbers.



Source: (Assessed on 10/04/2015)



How do Ponzi schemes and pyramid schemes differ? How are they similar?


What should be done to ensure large-scale fraud such as Ponzi schemes and pyramid schemes do not happen in the future?


Why are white-collar criminals such as Madoffable to carry out their schemes for so long when similar types of fraud often collapse at an early stage?


Highlight the ethical issues that you can think of, subject by subject in this case justifying why you believe they are indeed ethical or unethical

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