Saturday, January 24, 2009

Investing With Bernie Madoff: How It Happeneed, What Happened, And What Might Be Done. Part VI.

January 24, 2009

Re: Investing With Bernie Madoff: How It Happened,
What Happened, And What Might Be Done. Part VI.

The courses of action discussed here previously all have major shortcomings: they leave people very short of money to live on, they harm the innocent, they take way too long, they are uncertain. There is a different course of action, however, which would avoid most of these pitfalls. It would be speedy. It would be certain. It would give people their money back. It would put money back in the pockets of charities and pension plans. And it would greatly help restore confidence in investors, whose confidence has been badly shaken, and who, so long on their confidence remain shaken, are likely to stay away from investments in droves, which will “help” cripple efforts at economic recovery -- all as recognized by Congressmen at the January 5th hearing. It is a course of action which has been undertaken for the wealthiest corporations and individuals in the country. It is a course of action that will compensate for the most gross failure ever of government regulation, a factor responsible for the Madoff disaster. It is also a course of action which the smart money says is politically unpalable and will never happen, though done for others in monstrously huge amounts (of scores and hundreds of billions), because people are tired of it and here the people who lost money supposedly are nothing but a bunch of wealthy Jews.

The course of action is what can be called a “staggered-percentage bailout,” or in the alternative, could be a full bailout.

Here is how a staggered-percentage bailout would work. Recognizing that many of the people who lost half a million or a million dollars were using and need that money to survive, all people would receive the entire first one million of their losses from the government. For losses between two and five million dollars, people would receive 90% of their loss, or another $3.6 million for someone who lost $5 million (and who would thus obtain a total of $4.6 million). For losses between 5 to 20 million, a person would receive 80%, or another $12 million (or a total of $16.6 million) if the individual lost a full 20 million dollars. From 20 million to 100 million in losses a person would receive 70% of the loss, or another 56 million dollars (or a total of 72.6 million) if a person lost a full 100 million. Over 100 million a person would receive 60%. (This staged-percentage bailout is analogous to the income tax system in that it uses a staggered rate depending on wealth.)

The losses should be calculated on the basis of what a person honestly and reasonably thought he had in Madoff -- which for most people would be represented by their last statement, dated November 30, 2008. For what they honestly thought they had in Madoff is the basis on which people always acted, and would be expected to act in a capitalist system. (People who thought they had $1.5 million in Madoff and took out $125,000 a year to live, for example, would not have taken out that amount if they knew that in reality they only had $600,000 or so in Madoff. Charities that thought they had $15 million in Madoff would not have been giving out $1.6 million a year had they known they had only $6 million in Madoff, a reality they would have known but for governmental negligence.)

Persons who invested through funds and banks would be treated the same as persons who invested directly with Madoff, while the funds and banks would receive nothing (since the money is going directly to their investors).

There would be no recovery from SIPC or from the trustee in bankruptcy. There would be no tax refunds. There would be no tax deductions. The bailout would replace all of this. The government could, however, be subrogated to the rights of the bailed out individuals against anyone subject to lawsuit -- against negligent money mangers, and against FINRA, a private organization. The money mangers and FINRA could of course argue that the government is banned from recovering from them due to its own negligence.

This would be simple, quick, and clean. It would avoid the terror and uncertainty of claw backs, the incomplete recoveries from SIPC, the wiping out of charities and injury to pension funds, the years-long wait and pain caused to individuals by lawsuits. It might also cost the government little more than tax refunds and deductions. This is complicated to explain, at least for me, and we would need to know the actual numbers before estimates can be made with some certainty, but the general idea is this: Tax refunds and theft deductions will cost the government billions of dollars under current law with the estimate sometimes being $20 billion. The money received back in the near future via tax refunds will be invested, will earn income, and taxes will be paid on that income in the future by tax paying individuals. Those taxes will reduce the government’s “loss.” (At least taxes will be paid and the government’s “loss” reduced if enough is received back in refunds so that people can invest it instead of using it all to live.)

A similar idea obtains with theft deductions now and in the future. The money saved will be invested, will earn income on which taxes will be paid, and the taxes will reduce the government’s “loss.” This at least is true to the extent that people will not have to use the money saved in order to live, instead of investing it. Otherwise, the money may not be saved, invested, and earn income on which tax will be paid until many years into the future, because the theft loss has to be fixed pretty precisely before the tax deduction can be taken, and that won’t happen for a long time.

The situation with a bailout would be different in important ways, however. The government will “lose” the money paid as part of a bailout, but it will not “lose” money via tax refunds and via theft deductions taken now and in the future.

Moreover, the bailout monies given to taxpaying individuals will be invested and will start earning money immediately -- bailout money equal to what their statements showed they had in Madoff would enable people to live off earnings from investments rather than off of principal, just as they did when they thought they had the money in Madoff. Income taxes will therefore start being paid immediately by tax paying individuals on the invested money from the bailout. These income taxes will reduce the government’s “loss” from the bailout.

When all the numbers are known, it could well be that (i) the “loss” from the money paid in a staggered-percentage bailout, minus the “loss”-reducing tax paid on future earnings from the sums paid via bailout, may not be much more than (and might even be less than), (ii) the “loss” to the government because of tax refunds and present and future deductions for theft, minus the loss-reducing tax paid on earnings from invested monies that accrue to taxpayers because of tax refunds and deductions. And none of this even counts the “loss”-reducing amounts the government might recover in litigation due to subrogation to the rights of people who are bailed out.

Well, as warned, it’s complicated, and reasonably accurate estimates of the difference in the government’s “losses” await the facts. But even aside from the fact that a bailout might not cost the government much more than it will “lose” from tax refunds and deductions, a bailout has numerous and important advantages discussed above, not the least of which is that it is simple, will eliminate all the complications and uncertainties presently arising with regard to SIPC, claims made to the Trustee, tax refunds and theft deductions, and litigation, and it will help to re-engender all-important confidence in investors -- without whose investments our economy will sink beneath the waves -- by showing that government will act to protect people when its own gross, willful, incompetent failure to do its duty, and to stop a major crime, caused them to be wiped out.*

* This posting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, or on the comments of others, you can, if you wish, post your comment on my website, All comments, of course, represent the views of their writers, not the views of Lawrence R. Velvel or of the Massachusetts School of Law. If you wish your comment to remain private, you can email me at

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In addition, one hour long television book shows, shown on Comcast, on which Dean Velvel, interviews an author, one hour long television panel shows, also shown on Comcast, on which other MSL personnel interview experts about important subjects, conferences on historical and other important subjects held at MSL, and an MSL journal of important issues called The Long Term View, can all be accessed on the internet, including by video and audio. For TV shows go to:; for conferences go to:; for The Long Term View go to:­_LTV.htm.

Friday, January 23, 2009

Article: Madoff tops charts; skeptics ask how. By Michael Ocrant

MAR/Hedge (RIP)
No. 89 May 2001

Madoff tops charts; skeptics asks how
Madoff tops charts;
skeptics ask how

By Michael Ocrant

Mention Bernard L. Madoff Investment Securities to anyone working on Wall Street at any time over the last 40 years and you’re likely to get a look of immediate recognition.

After all, Madoff Securities, with its 600 major brokerage clients, is ranked as one of the top three market makers in Nasdaq stocks, cites itself as probably the largest source of order flow for New York Stock Exchange-listed securities, and remains a huge player in the trading of preferred, convertible and other specialized securities instruments.

Beyond that, Madoff operates one of the most successful “third markets” for trading equities after regular exchange hours, and is an active market maker in the European and Asian equity markets. And with a group of partners, it is leading an effort and developing the technology for a new electronic auction market trading system called Primex.

But it’s a safe bet that relatively few Wall Street professionals are aware that Madoff Securities could be categorized as perhaps the best risk-adjusted hedge fund portfolio manager for the last dozen years. Its $6–7 billion in assets under management, provided primarily by three feeder funds, currently would put it in the number one or two spot in the Zurich (formerly MAR) database of more than 1,100 hedge funds, and would place it at or near the top of any well-known database in existence defined by assets.

More important, perhaps, most of those who are aware of Madoff’s status in the hedge fund world are baffled by the way the firm has obtained such consistent, nonvolatile returns month after month and year after year.

Madoff has reported positive returns for the last 11-plus years in assets managed on behalf of the feeder fund known as Fairfield Sentry, which in providing capital for the program since 1989 has been doing it longer than any of the other feeder funds. Those other funds have demonstrated equally positive track records using the same strategy for much of that period.

Lack of volatility

Those who question the consistency of the returns, though not necessarily the ability to generate the gross and net returns reported, include current and former traders, other money managers, consultants, quantitative analysts and fund-of-funds executives, many of whom are familiar with the so-called splitstrike conversion strategy used to manage the assets.

These individuals, more than a dozen in all, offered their views, speculation and opinions on the
condition that they wouldn’t be identified. They noted that others who use or have used the strategy— described as buying a basket of stocks closely correlated to an index, while concurrently selling out-ofthe-money call options on the index and buying out-of-the-money put options on the index—are known to have had nowhere near the same degree of success.

The strategy is generally described as putting on a “collar” in an attempt to limit gains compared to the benchmark index in an up market and, likewise, limit losses to something less than the benchmark in a down market, essentially creating a floor and a ceiling.

Madoff’s strategy is designed around multiple stock baskets made up of 30–35 stocks most correlated to the S&P 100 index. In marketing material issued by Fairfield Sentry, the sale of the calls is described as increasing “the standstill rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls.” The puts, according to the same material, are “funded in large part by the sale of the calls, [and] limit the portfolio’s downside.

“A bullish or bearish bias can be achieved by adjusting the strike prices of the options, overweighting the puts, or underweighting the calls. However, the underlying value of the S&P 100 puts is always approximately equal to that of the portfolio of stocks,” the marketing document concludes.

Throughout the entire period Madoff has managed the assets, the strategy, which claims to use OTC options almost entirely, has appeared to work with remarkable results.
Again, take the Fairfield Sentry fund as the example. It has reported losses of no more than 55 basis points in just four of the past 139 consecutive months, while generating highly consistent gross returns of slightly more than 1.5% a month and net annual returns roughly in the range of 15.0%.

Among all the funds on the database in that same period, the Madoff/Fairfield Sentry fund would place at number 16 if ranked by its absolute cumulative returns.

Among 423 funds reporting returns over the last five years, most with less money and shorter track records, Fairfield Sentry would be ranked at 240 on an absolute return basis and come in number 10 if measured by risk-adjusted return as defined by its Sharpe ratio.

What is striking to most observers is not so much the annual returns—which, though considered
somewhat high for the strategy, could be attributed to the firm’s market making and trade execution capabilities—but the ability to provide such smooth returns with so little volatility.

The best known entity using a similar strategy, a publicly traded mutual fund dating from 1978 called Gateway, has experienced far greater volatility and lower returns during the same period.

The capital overseen by Madoff through Fairfield Sentry has a cumulative compound net return of 397.5%. Compared with the 41 funds in the Zurich database that reported for the same historical period, from July 1989 to February 2001, it would rank as the best performing fund for the period on a riskadjusted basis, with a Sharpe ratio of 3.4 and a standard deviation of 3.0%. (Ranked strictly by standard deviation, the Fairfield Sentry funds would come in at number three, behind two other market neutral funds.)

Questions abound

Bernard Madoff, the principal and founder of the firm who is widely known as Bernie, is quick to note that one reason so few might recognize Madoff Securities as a hedge fund manager is because the firm makes no claim to being one.

The acknowledged Madoff feeder funds—New York-based Fairfield Sentry and Tremont Advisors’ Broad Market; Kingate, operated by FIM of London; and Swiss-based Thema—derive all the incentive fees generated by the program’s returns (there are no management fees), provide all the administration and marketing for them, raise the capital and deal with investors, says Madoff.

Madoff Securities’ role, he says, is to provide the investment strategy and execute the trades, for which it generates commission revenue.

[Madoff Securities also manages money in the program allocated by an unknown number of
endowments, wealthy individuals and family offices. While Bernie Madoff refuses to reveal total assets under management, he does not dispute that the figure is in the range of $6 billion to $7 billion.]

Madoff compares the firm’s role to a private managed account at a broker-dealer, with the brokerdealer providing investment ideas or strategies and executing the trades and making money off the account by charging commission on each trade.

Skeptics who express a mixture of amazement, fascination and curiosity about the program wonder, first, about the relative complete lack of volatility in the reported monthly returns.

But among other things, they also marvel at the seemingly astonishing ability to time the market and move to cash in the underlying securities before market conditions turn negative; and the related ability to buy and sell the underlying stocks without noticeably affecting the market.

In addition, experts ask why no one has been able to duplicate similar returns using the strategy and why other firms on Wall Street haven’t become aware of the fund and its strategy and traded against it, as has happened so often in other cases; why Madoff Securities is willing to earn commissions off the trades but not set up a separate asset management division to offer hedge funds directly to investors and keep all the incentive fees for itself, or conversely, why it doesn’t borrow the money from creditors, who are generally willing to provide leverage to a fully hedged portfolio of up to seven to one against capital at an interest rate of Libor-plus, and manage the funds on a proprietary basis.

These same skeptics speculate that at least part of the returns must come from other activities related to Madoff’s market making. They suggest, for example, that the bid-ask spreads earned through those activities may at times be used to “subsidize” the funds.

According to this view, the benefit to Madoff Securities is that the capital provided by the funds could be used by the firm as “pseudo equity,” allowing it either to use a great deal of leverage without taking on debt, or simply to conduct far more market making by purchasing additional order flow than it would otherwise be able to do.

And even among the four or five professionals who express both an understanding of the strategy and have little trouble accepting the reported returns it has generated, a majority still expresses the belief that, if nothing else, Madoff must be using other stocks and options rather than only those in the S&P 100.

Bernie Madoff is willing to answer each of those inquiries, even if he refuses to provide details about the trading strategy he considers proprietary information.

And in a face-to-face interview and several telephone interviews, Madoff sounds and appears
genuinely amused by the interest and attention aimed at an asset management strategy designed to generate conservative, low risk returns that he notes are nowhere near the top results of well-known fund managers on an absolute return basis.

Lack of volatility illusory

The apparent lack of volatility in the performance of the fund, Madoff says, is an illusion based on a review of the monthly and annual returns. On an intraday, intraweek and intramonth basis, he says, “the volatility is all over the place,” with the fund down by as much as 1%.

But as whole, the split-strike conversion strategy is designed to work best in bull markets and, Madoff points out, until recently “we’ve really been in a bull market since ‘82, so this has been a good period to do this kind of stuff.”

Market volatility, moreover, is the strategy’s friend, says Madoff, as one of the fundamental ideas is to exercise the calls when the market spikes, which with the right stock picks would add to the performance.

In the current bearish environment, when some market experts think the fund should have been showing negative returns, albeit at levels below the benchmark index, managing the strategy has become more difficult, says Madoff, although performance has remained positive or, as in February, flat.

The worst market to operate in using the strategy, he adds, would be a protracted bear market or “a flat, dull market.” In a stock market environment similar to what was experienced in the 1970s, for instance, the strategy would be lucky to return “T-bill like returns.”

Market timing and stock picking are both important for the strategy to work, and to those who express astonishment at the firm’s ability in those areas, Madoff points to long experience, excellent technology that provides superb and low-cost execution capabilities, good proprietary stock and options pricing models, well-established infrastructure, market making ability and market intelligence derived from the massive amount of order flow it handles each day.

The strategy and trading, he says, are done mostly by signals from a proprietary “black box” system that allows for human intervention to take into account the “gut feel” of the firm’s professionals. “I don’t want to get on an airplane without a pilot in the seat,” says Madoff. “I only trust the autopilot so much.”

As for the specifics of how the firm manages risk and limits the market impact of moving so much capital in and out of positions, Madoff responds first by saying, “I’m not interested in educating the world on our strategy, and I won’t get into the nuances of how we manage risk.” He reiterates the undisputed strengths and advantages the firm’s operations provide that make it possible.

Multiple stock baskets

Avoiding market impact by trading the underlying securities, he says, is one of the strategy’s primary goals. This is done by creating a variety of stock baskets, sometimes as many as a dozen, with different weightings that allow positions to be taken or unwound slowly over a one- or two-week period.

Madoff says the baskets comprise the most highly capitalized liquid securities in the market, making the entry and exit strategies easier to manage.

He also stresses that the assets used for the strategy are often invested in Treasury securities as the firm waits for specific market opportunities. He won’t reveal how much capital is required to be deployed at any given time to maintain the strategy’s return characteristics, but does say that “the goal is to be 100%

The inability of other firms to duplicate his firm’s success with the strategy, says Madoff, is
attributable, again, to its highly regarded operational infrastructure. He notes that one could make the same observation about many businesses, including market making firms.

Many major Wall Street broker-dealers, he observes, previously attempted to replicate established market making operations but gave up trying when they realized how difficult it was to do so successfully, opting instead to acquire them for hefty sums.

[Indeed, says Madoff, the firm itself has received numerous buyout offers but has so far refused any entreaties because he and the many members of his immediate and extended family who work there continue to enjoy what they do and the independence it allows and have no desire to work for someone else.]

Similarly, he adds, another firm could duplicate the strategy in an attempt to get similar results, but its returns would likely be unmatched because “you need the physical plant and a large operation” to do it with equal success. However, many Wall Street firms, he says, do use the strategy in their proprietary trading activities, but they don’t devote more capital to such operations because their return on capital is better used in other operations.

Setting up a proprietary trading operation strictly for the strategy, or a separate asset management division in order to collect the incentive fees, says Madoff, would conflict with his firm’s primary business of market making.

Commissions suffice

“We’re perfectly happy making the commissions” by trading for the funds, he says, which industry observers note also gives the firm the entirely legitimate opportunity to “piggyback” with proprietary trading that is given an advantage by knowing when and where orders are being placed.

Setting up a division to offer funds directly, says Madoff, is not an attractive proposition simply
because he and the firm have no desire to get involved in the administration and marketing required for the effort, nor to deal with investors.

Many parts of the firm’s operations could be similarly leveraged, he notes, but the firm generally
believes in concentrating on its core strengths and not overextending itself. Overseeing the capital provided by the funds and its managed accounts, he says, provides another fairly stable stream of revenue that offers some degree of operational diversification.

Madoff readily dismisses speculation concerning the use of the capital as “pseudo equity” to support the firm’s market making activities or provide leverage. He says the firm uses no leverage, and has more than enough capital to support its operations.

He notes that Madoff Securities has virtually no debt and at any given time no more than a few
hundred million dollars of inventory.

Since the firm makes markets in only the most highly capitalized, liquid stocks generally represented by the S&P 500 index, a majority of which are listed on the NYSE, as well as the 200 most highly capitalized Nasdaq-listed stocks, says Madoff, it has almost no inventory risk.
Finally, Madoff calls ridiculous the conjecture that the firm at times provides subsidies generated by its market making activities to smooth out the returns of the funds in a symbiotic relationship related to its use of the capital as a debt or equity substitute. He agrees that the firm could easily borrow the money itself at a fairly low interest rate if it were needed, and would therefore have no reason to share its profits.“Why would we do that?”

Still, when the many expert skeptics were asked by MAR/Hedge to respond to the explanations about the funds, the strategy and the consistently low volatility returns, most continued to express bewilderment and indicated they were still grappling to understand how such results have been achieved for so long.

Madoff, who believes that he deserves “some credibility as a trader for 40 years,” says: “The strategy is the strategy and the returns are the returns.” He suggests that those who believe there is something more to it and are seeking an answer beyond that are wasting their time.

Investing With Bernie Madoff: How It Happeneed, What Happened, And What Might Be Done. Part V.

January 23, 2009

Re: Investing With Bernie Madoff: How It Happened,
What Happened, And What Might Be Done. Part V.

I turn now from preliminary comments to specific courses of action. As you will see, each course of action being generally discussed in the media today will be insufficient, will be too little, too late, especially because the law is not designed to handle a disaster of this magnitude.

There is, first, the Security Investors Protection Act, commonly referred to as SIPC (pronounced Sipic). Under this Act investors can receive up to $500,000. But, if they have taken money out of Madoff, this might be subtracted from the amount they receive -- it is not yet completely clear how SIPC intends to handle this question, although one major straw in the wind could be that the head of SIPC told Congress that SIPC would reasonably quickly pay people who could show they never took money out of Madoff. However, SIPC will not cover persons who invested through a fund, rather than directly with Madoff. (One person has filed a petition requesting that this limitation be dropped.) SIPC covers only a portion of people’s losses, even small people. And if SIPC subtracts from the $500,000 the amounts that a person has taken out of Madoff, it is likely that those who are most desperate will get nothing: those who were living off what they thought were their earnings from Madoff -- e.g., older people -- have been taking money out every year, and likely would get no money from SIPC.

Then there is the possibility of recovery from the Trustee in Bankruptcy, who has taken over Madoff’s business and estate, is seeking hidden monies, and will divide proceeds among the investors. A problem here is that it is widely thought that the Trustee is not going to uncover much money, at least not in comparison to the amounts investors are owed. So investors will get little back from the Trustee.

Another problem here is the so-called clawback problem. The media, and lawyers whom it quotes for reflexive positions representing the conventional wisdom, say that people who took money out of Madoff during the last six years will have to give back that money -- this is the so-called clawback. This is terrifying to people, and, rightly so. Having been wiped out, or having suffered a huge loss that leaves one with only a small percentage of what one had, people now face the prospect of being obligated to give back six years of withdrawals -- often withdrawals they needed to live, as with older people, or for perfectly reasonable purposes like buying a house. However, what is given much less media play is that, as I read the leading case in the field, clawbacks, in part at least, will not apply to people who had no inkling that anything was wrong -- as true of so many of Madoff’s victims. It applies only to people who took out money after learning of facts that reasonably should have put them on notice that something was wrong (and it would apply, I assume, though I haven’t read anything explicit on this, only to money they took out after being put on such notice). And finally, clawbacks will not apply, I believe, to the extent that money innocently taken out, with no knowledge of possible illegality, did not exceed the principal put in.

It is, of course, in a way quite perverse to claw back money form people who took out their money after they learned that something could conceivably be wrong. For taking out their money then, as I think one pension plan actually did if I remember correctly, is exactly what one would expect and hope they would do. What else should they have done -- left their money in if they believed it was being stolen? Of course, it is possible that they should have gone to the SEC but didn’t, and there are theories under which this could also make them liable to others, but leaving their money in to be stolen by Madoff hardly seems what a capitalist system expects from people.

Whether the Trustee in Bankruptcy is going to insist on clawbacks, at least from those who were not completely innocent of knowledge that something unlawful was happening, is unknown. But people remain terrified of the possibility, and as the media has said, many who innocently took out monies are considering not making claims either to SIPC or the Trustee lest their withdrawals come to these parties’ attention when otherwise they might not due to the abominable condition of Madoff’s records. Victims of Madoff are understandably terrified of being denuded of their few remaining assets, if any.

Then there are tax refunds. Persons who took supposed earnings (shown by their monthly statements) out of Madoff -- to live, for example, or to buy a house -- paid income taxes on that money at the rates applied to ordinary income -- roughly a bit more than one-third the supposed earnings. They can get refunds of their last three years of taxes (2005, 2006 and 2007), and of estimated taxes already paid on the supposed Madoff earnings in 2008. But this will amount to only a fraction of the total income taxes many of them paid on supposed Madoff income (called phantom income) over the years -- over 20 or 30 years of investing with Madoff.

You know, if these people had been committing tax fraud on the government for the 20 or 25 years, so that the government never got the tax it was entitled to, the government could go back and collect the taxes -- with interest -- for the full period of 20 or 25 years. But when the government, for 20 or 25 years, got taxes it was not entitled to because the tax was paid on phantom income, and when the horrible dereliction of a government agency is heavily responsible for the people thinking they had real income and paying taxes on it to the government, the people get refunds for only three years. The government can get all 20 or 25 years, the people can get only three years. This does not seem fair, and still less so in the context of governmental dereliction. If you ask me, there should be a special law allowing Madoff victims who paid taxes on phantom income to the government -- taxes which would not have been paid but for governmental dereliction -- to recover all the taxes they paid on phantom income. This would go some way towards easing the financial problem -- the problem of how to live -- of many Madoff victims, especially those who have been economically devastated. Refunds of income tax will not, however help all investors. In particular, charities and pension plans that were crippled or wiped out are nonprofit, tax-free organizations. So they never paid income tax, and will get no refunds of tax. Neither will people whose IRA monies were in Madoff, because they too paid no taxes on supposed earnings from Madoff.

There is also another tax consequence besides refunds for people who paid income tax on phantom income. There is a theft deduction for the amount lost by fraud. The deduction can be taken against income in 2008, when the theft was discovered, can be used against (can be “carried back” against) the three prior years’ income (2005, 2006, and 2007), and can be carried forward for 20 years.

But there are huge problems with the theft deduction. The exact amount of the deduction that can be taken is a matter of great dispute, involving complex tax ideas that are incomprehensible to laymen and even to attorneys who are not tax lawyers. As is proverbial in other tax areas, if you put ten tax accountants and tax lawyers in a room, you might get ten different answers as to how much can be taken as a theft deduction. And the IRS may fight to keep the theft deduction as low as possible.

Then too, while the theft deduction has to be declared by an individual in 2008, the year in which the theft was discovered, the government may not allow it to actually be used for years -- conceivably for five or ten years or even more. For it cannot be used until the exact amount of the theft loss is known with pretty fair certainty. But if one claims money from SIPC, or engages in litigation to try to recover money -- as I would bet most will -- then the IRS can claim that the amount of the theft loss is uncertain while the SIPC claim or the litigation claims hang fire, and the theft loss will be unusable until the SIPC and litigation proceedings are finished, which is likely to take years.

The theft loss deduction is also of no use to the charities or pension plans which got crippled or wiped out. For, as said, they are tax free nonprofits. They therefore pay no income taxes, have no past, present or future tax payments against which to deduct theft losses, and will obtain no benefit from any theft loss deductions. Ditto those who invested through IRAs.

This brings me to the question of lawsuits, several of which have already been filed.

Let me start with the question of suing the SEC. (One such suit has already been filed.) The “smart money,” the lawyers whom the media quote, reflexively provide the conventional wisdom that this cannot be done -- the government is immune from suit, the SEC was exercising permissible discretion, etcetera, etcetera. Well, I’m not at all sure that the conventional wisdom is right in this case. In fact, I think it may be quite wrong, and that there are at least three theories on which the government could well be liable to investors for their losses. I don’t intend to get into those theories or the ideas underlying them here, except to make a general comment.

To wit: we have here a situation in which the SEC acted in gross violation of the public policy that the agency has been obligated to uphold since it was created in, I think, 1933. It is obligated, it has a duty to all citizens, to prevent fraud upon them. It has no discretion -- none -- to fail to follow up, with serious investigations, when presented with knowledgeable, detailed, obviously highly competent, and in many respects easily “checkable” allegations of the most serious fraud, of a huge fraud that is fooling thousands of people, stealing billions of dollars, and causing horrible injustice. It has no discretion, none, to thwart in such manner the basic purpose of the statute, the basic policy the statute established, the will of Congress, and the SEC’s own raison d’etre. The SEC’s incredible willful negligence, its defacto (or, who knows, maybe even de jure?) complicity do, I think, make it liable to suit in this case under several different theories, even if it is not liable in other cases involving much different facts.

Then there is the possibility of suit against FINRA. Unlike the SEC, FINRA is not a governmental organization, but a private one. Thus arguments from conventional wisdom as to why it’s not possible to sue the SEC do not even apply against FINRA, as far as I can see. FINRA and its predecessors, particularly the NASD, appear to have been as incredibly negligent as the SEC, and will be sued once people learn of the inspections and negligence in the Madoff matter of FINRA and its predecessor, the NASD (both headed by Mary Schapiro, who now will head the SEC).

A major reason FINRA will surely be sued is that, if I understand correctly -- and I think I do but would surely like to be told if I am wrong -- (i) FINRA is a membership organization whose members comprise pretty much the entire brokerage community in the United States, including, probably, at least several of the huge, now bailed out investment banking houses because they usually had brokerage arms (e.g., Merrill Lynch) or even were mainly brokerage houses, and (ii) FINRA may well have the capacity (as does the SIPC) to assess its membership for money. If these assumptions are correct, virtually the entire brokerage industry in the United States, including vast bailed-out houses, all of whom could be assessed by FINRA, could be on the hook financially due to FINRA’s incredible negligence in inspecting Madoff. FINRA would thus represent a very deep pocket capable of paying all the losses of investors in Madoff. It would, of course, be only poetic justice for the losses to be paid by the brokerage/investment banking community, since that community is so fundamentally responsible in so many ways for the country’s entire financial meltdown -- which, by the way, is also thought to have triggered the redemption requests made to Madoff by funds, requests that are in turn thought to have triggered Madoff’s meltdown.

There also will be litigation against huge funds and banks that gave Madoff billions of dollars without doing due diligence, which they surely did have the money and knowledge to do or to have done for them, and which other large funds and banks here and abroad did do (and therefore decided not to invest in Madoff). These funds and banks had and failed in a duty of diligence owed to their investors, whose money they put in Madoff, and they will be sued by their investors. It is commonly thought that they had no duty to, and therefore cannot be sued by, persons who invested directly in Madoff rather than through a fund. I think there is a theory which such persons could use against the funds and banks, but I do not place a lot of stock in it.

(With regard to banks, there seem to be legitimate questions regarding Chase Bank. I have read that Madoff’s sole account was with that bank. Chase never had reason to question transactions in the account, did it, e.g., large checks being sent to Swiss banks or to Lichtenstein or the Cayman Islands? I’ve also read that the wife of Frank DiPascali -- who is Madoff’s number two man and must certainly have been himself involved in the fraud -- was an officer of Chase. She didn’t supervise Madoff’s account, did she? I have no reason to think Chase has any fault, but these questions must at least be asked, especially since these days nothing seems impossible.)

Then there is the question of suit against experts who ferreted out that something was rotten in the state of Madoff, who may even have advised clients or their companies not to put money in or deal with Madoff, and who did not bring to the SEC their suspicions and the well taken reasons for them. Can these people be liable because, if they, in what appear to be their possibly significant numbers, had informed the SEC of their suspicions, as did Markopolos, perhaps there would have been enough complaints to move the SEC off the dime? Well, I think it would be true in fact that complaints from all these people could have created a critical mass that would have had an impact, but for several reasons I would not bet my last farthing, or maybe even my first one, that suits against them would be successful.*


* This posting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, or on the comments of others, you can, if you wish, post your comment on my website, All comments, of course, represent the views of their writers, not the views of Lawrence R. Velvel or of the Massachusetts School of Law. If you wish your comment to remain private, you can email me at

VelvelOnNationalAffairs is now available as a podcast. To subscribe please visit, and click on the link on the top left corner of the page. The podcasts can also be found on iTunes or at

In addition, one hour long television book shows, shown on Comcast, on which Dean Velvel, interviews an author, one hour long television panel shows, also shown on Comcast, on which other MSL personnel interview experts about important subjects, conferences on historical and other important subjects held at MSL, and an MSL journal of important issues called The Long Term View, can all be accessed on the internet, including by video and audio. For TV shows go to:; for conferences go to:; for The Long Term View go to:­_LTV.htm.

Thursday, January 22, 2009

Investing With Bernie Madoff: How It Happeneed, What Happened, And What Might Be Done. Part IV.

January 22, 2009

Re: Investing With Bernie Madoff: How It Happened,
What Happened, And What Might Be Done. Part IV.

In the final three installment of the posts on the Madoff mess, I will discuss how much was stolen, where did it go, and what can be done for victims.

The amount stolen is currently impossible to know. When arrested, Madoff said $50 billion was lost. It is widely surmised that, in saying 50 billion, he was claiming the amounts shown on the latest monthly statements to investors, which were dated November 30, 2008. It’s also possible that 50 billion is the total amount of principal actually invested over the years, not all of which was lost to investors because lots of them must have fully redeemed their investments over the 20 to 45 years or so of his Ponzi scheme. And recently, one reads, the government is estimating the loss at about 37 billion, but whether this is the amount shown on the latest statements or the amount actually invested is uncertain.

One thing all the estimates of loss have in common, though, is that they are all big numbers. Even when they are based on the most recent statements, it is clear that many, many billions of invested principal was lost. So where did the money go?

Just for kicks, assume that, over the years, 60 billion dollars of principal was invested with Madoff, that a third of it, or $20 billion, was redeemed, and that another third, or another $20 billion, was taken out by investors who thought they were getting income. What happened to the remaining $20 billion, to the earnings that this $20 billion were making when Madoff invested it, and to the earnings of the other, redeemed and withdrawn $40 billion while it remained with Madoff? You can change the assumed numbers I’ve used, but the question of what happened to the money will remain unless one supposes that every dollar of the enormous sums Madoff took in over the years, plus the money he earned investing those sums, was withdrawn over the years as a redemption of principal or as withdrawal of (falsely supposed?) earnings. And personally, I won’t believe such a supposition until it is shown to be true; the sums are too large and my suspicion is that too many people put in huge sums and let the money ride rather than withdrawing it.

So, if I am right, where are the many billions that are liable to be left? Where did they go? Has Madoff stashed them in Swiss banks? Are they in real estate or stocks and bonds all over the world? Was Madoff the king of bad investors, so that he lost tens or scores of billions in the market over the years so that there truly is nothing left? Was this, as at least a few suspect, a Mafia operation in which billions upon billions were siphoned off by the mob? Who knows? All I can say is that one hopes the government finds out the answers and that, as said, until shown the contrary, it is hard to believe that every nickel Madoff took in and every nickel he made by investing was lost.

Indeed, it has been written that Madoff got into trouble this autumn because he was having difficulty coming up with enough money to meet a $7 billion dollar request for redemption by one of his feeder funds, Fairfield Sentry. Doesn’t this seem to imply that he had several billions? -- Was he really trying to raise fully seven billion in just a few weeks?

Now for the question of what can be done.

Before discussing specific courses of action, though, I want to make three preliminary but vital points. As you will see, the current law is seriously ill equipped to remedy this horrible situation. Such a disaster as a $50 billion dollar Ponzi scheme that wiped out thousands, left old people destitute by the many hundreds or thousands, destroyed or injured charities, injured pension funds, and demolished confidence in the market was simply never foreseen by the law and never prepared for in the law.

As well, many of the investors in Madoff were people who did exactly what is supposed to be done in a capitalist system. They worked like dogs all their lives, they saved up a million or two million dollars for their old age, and then invested it with someone whose eminent positions, leadership in the financial world, and decades of putative success made him seem eminently trustworthy; and they depended upon government -- upon the SEC -- to protect them against a fraud, particularly because their own ability to ferret out Madoff’s scheme was very limited or nonexistent.

Protecting against fraud has been the SEC’s duty to citizens, its duty to them, since its creation in the 1930s, and small people, as said, had no ability to ferret out Madoff’s scheme on their own. These are not the billionaires, or the huge institutions, that could hire expensive experts in due diligence. Nor did they even know that such due diligence experts-for-hire existed. These are the plain people who worked hard and saved all their lives, as capitalism says they should, and who, as so many legislators and witnesses said at the hearing of January 5th, depended on their government to protect them and had every right to do so, but were failed by their government, were horribly failed by it, because of one of the most willfully negligent, incompetent, and perhaps even complicitous courses of action any agency has ever engaged in.

Finally, there is this. Several have indicated to me that there is a current of prejudice running through the position of those who say the government should do little or nothing to alleviate what Madoff did to people and that it is politically unpalatable to help the victims. The idea underlying these comments is that people think that those who suffered are just a bunch of rich Jews, so the hell with them. This is sheer anti-Semitism. It’s also wrong on crucial facts. Yes, there were very wealthy Jews who lost fortunes, the kinds of people who, along with large institutions, the mainstream media has so extensively focused on. But there were lots of small people in their 60s and 70s and 80s who now don’t know how they are going to live. There were lots of people who aren’t Jewish. There were small charities that sponsored vital medical research that has and will benefit billions of people of all races and religions. There are pension plans for firemen. And the refusal, the claimed unpalatability, of helping the victims of Madoff contrasts badly, does it not, with the fact that huge banks, investment houses, huge insurance companies, and giant auto companies, each of which was itself worth scores or hundreds of billions of dollars, are each receiving scores and even hundreds of billions of dollars in bailout monies, are receiving it although these companies and their executives, who make tens and scores of millions each year, were not victims of any fraud or illegality, much less criminal fraud or illegality that the government had a duty to stop, but instead made stupid, greedy decisions that ran the companies into the ground -- decisions, moreover, perpetrated by the very executives whose multimillion dollar salaries will be saved by the bailouts, whose salaries of ten and twenty million dollars and more will be saved by the bailouts.*


*This posting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, or on the comments of others, you can, if you wish, post your comment on my website, All comments, of course, represent the views of their writers, not the views of Lawrence R. Velvel or of the Massachusetts School of Law. If you wish your comment to remain private, you can email me at

VelvelOnNationalAffairs is now available as a podcast. To subscribe please visit, and click on the link on the top left corner of the page. The podcasts can also be found on iTunes or at

In addition, one hour long television book shows, shown on Comcast, on which Dean Velvel, interviews an author, one hour long television panel shows, also shown on Comcast, on which other MSL personnel interview experts about important subjects, conferences on historical and other important subjects held at MSL, and an MSL journal of important issues called The Long Term View, can all be accessed on the internet, including by video and audio. For TV shows go to:; for conferences go to:; for The Long Term View go to:­_LTV.htm.

Wednesday, January 21, 2009

Investing With Bernie Madoff: How It Happeneed, What Happened, And What Might Be Done. Part III.

January 21, 2009

Re: Investing With Bernie Madoff: How It Happened,
What Happened, And What Might Be Done. Part III.

The SEC’s failure to investigate and put an end to Madoff’s crime, its announcing in 1992 that there was no problem with Madoff and its failure ever to correct that statement, its consequent sabotaging of thousands of investors with the literal impoverishing of countless numbers and the crippling of many charities, medical research organizations and injury to pension funds, must be one of the greatest regulatory failures in American history, if not the single greatest failure. Time after time the SEC had the opportunity to act. Time after time it was warned. Time after time it did little or nothing. Time after time, in fact every single time according to both witness testimony and Congressional statements at the hearing of January 5th, it did not subpoena Madoff’s books and records or testimony, but instead merely accepted whatever he chose to voluntarily tell it and whatever records he chose to voluntarily give it. Had it just once demanded his books and records, had it just once demanded to see securities he claimed to be buying and selling, had it just once checked whether claimed trades of securities and purchases of puts had occurred, the game would have been over for Madoff. But instead of stopping his crime, the SEC allowed him to continue as a one-man-wrecking-crew.

The SEC was at minimum willfully, horribly negligent. There are those, including at least one Congressman, who think it was complicitous.

As discussed previously, the SEC investigated the situation existing with regard to Bienes and Avellino in 1992, and said Madoff was doing nothing wrong. As indicated at the January 5th hearing, it must not have subpoenaed and inspected his books and records then; otherwise it couldn’t have said there was nothing to indicate fraud. Later Markopolos warned it both verbally and in writing in 1999 or early 2000. But the SEC did little or nothing, including not warning the public that serious red flags had been presented by a sophisticated, mathematically-expert analyst who worked with derivatives and had used the same investment system as Madoff. Then, when little known articles, the major one in a highly obscure professional publication unknown to the general public, appeared in 2001, after Markopolos’ warning, the SEC again failed to protect the public.

The SEC received more complaints about Madoff in the years between 2001 and 2005, I understand, and one gathers it may have “sort of” looked at the Madoff situation in a truncated way. But it did nothing to protect the public. Then in 2005 Markopolos sent it the 2005 version of his memo.

Starting in 2005 or 2006, the SEC apparently did inspect Madoff, perhaps sparked by Markopolos’ 2005 memo. It found some violations in his broker-dealer conduct, which have been passed off, rightly or wrongly, as technical and trivial. But it also found, after at least 20 years and maybe after 45 years of his doing so, that he also had been running an unlawfully unregistered investment management business. What did it do after finding out, after decades, that he was running an unregistered management advisory business? Did it make him stop running the business? Did it closely examine the business to find out whether a business that had been kept secret from it by Madoff for 20 or 45 years was on the up and up? No and no. All it did was it merely required him to register. It did not conduct an examination of the investment manager business, nor did it subpoena the books and records. I reiterate: after two to 4½ decades of illegality, it merely required him to register. It is little wonder that some think there had to be SEC complicity.

It is my understanding, at least I have read -- and please correct me if I am mistaken -- that the SEC is obligated to examine an investment manager when he first registers. If this is true, the SEC failed in this too, and thus failed again to protect the public, as it did so many other times.

You know, as I read over what has been written here, it seems desirable to quote the exact language used by Karen Scannell of the Wall Street Journal on January 5th. Speaking of the SEC’s examination, she says:

In 2005, the New York staff began a broader examination, interviewing Mr. Madoff, his brother, two sons and a niece, all of whom worked at the firm. The SEC found that his investment-advisory business had 16 clients and managed $8 billion. Any firm that offers advice to more than 14 clients is required to register with the agency and undergo review.

* * * * *

The [SEC] examination uncovered some technical trading violations.

* * * * * *

The SEC also found that Mr. Madoff misled the agency in 2005 about the strategy he used for customer accounts, withheld information about the accounts and violated SEC rules by operating as an unregistered investment adviser. “The staff found no evidence of fraud,” according to the SEC case memo. Mr. Madoff agreed to register his business that September, and the SEC didn’t make its findings public. (Emphases added.)

This is frankly staggering. The SEC interviewed Madoff, his brother, his son and his niece, and found that the investment advisory business had only 16 clients when he was running money for thousands of people? Thousands. And his relatives are supposed to be innocent? What did they tell the SEC?

And the SEC found Madoff had “misled the agency in 2005 about the strategy he used for customer accounts” and “withheld information about the accounts.” (Emphases added.) What does this mean? It sounds to me like “misleading the agency . . . about the strategy he used for customers’ accounts” could very well mean, perhaps even probably means, that he falsely told it he was using the split-strike conversion strategy, as he told everyone else, but in reality was not doing so. (Or maybe the reverse of these facts, but either way he had lied.) He lied to the SEC about his strategy, yet “the SEC didn’t make its findings public,” so the customer would know, but instead left his thousands of customers to twist in the wind, to be left in the lurch, to be unable to “defend themselves” and to lose all their money a few years later when they lost even more than they would have then? Wow!

One wonders as well about complicity of a slightly different form. With the extensive revolving door between Wall Street and the SEC, a revolving door that goes from young lawyers to midlevel bureaucrats to commissioners, and with so many people on Wall Street knowing that Madoff was investing money for large numbers of people (and probably often knowing as well of the wide disbelief about Madoff on Wall Street), how is it that nobody at the SEC who had been on Wall Street thought to inquire whether Madoff was registered as an investment adviser?

So, as said, the SEC was a 16 year (or maybe a 45 year) perfect storm of the most thorough, willful negligence, if not de jure or defacto complicity. But it was not the only agency which failed the public. There is also FINRA, the Financial Industry Regulatory Authority and its predecessors.

FINRA’s website says that its “overarching objectives” are “investor protection and market integrity.” FINRA was formed in 2007, as a combination of two prior investor protection bodies, the regulation and enforcement branch of the New York Stock Exchange and the NASD, which had a regulatory function. Its president is Mary Schapiro, who was an SEC Commissioner from 1988-1994, was head of the NASD until 2007, became head of FINRA when it was created in 2007, and is now slated to become head of the SEC.

My understanding is that FINRA, unlike the SEC, is a private self regulatory organization, not a governmental organization, and that its members pretty much constitute the whole brokerage industry. That was the case with its predecessor organizations, I gather, and is the case with their successor, FINRA. If this is right, as I believe it is, it could be a crucial fact for reasons discussed below.

FINRA investigates broker dealers, as did its predecessors, the NASD and the regulatory arm of the NYSE. In 2007 FINRA investigated Madoff, as had the NASD before it, most lately in 2005. (Representative Kanjorski said at the January 5th hearing that FINRA, obviously meaning FINRA and one of its predecessors, had inspected Madoff’s broker-dealer operation at least once every two years since 1989, and it has subsequently been confirmed that Madoff was inspected every two years since he started his business.) I also gather that FINRA found little wrong with Madoff in 2007, concluding only that he violated some technical rules and had not reported some transactions on a timely basis. It found nothing with regard to Madoff’s Ponzi scheme. Let me again quote Karen Scannell of the WSJ on January 5th:

FINRA . . . . conclude[ed] in 2007 that it [Madoff] violated technical rules and failed to report certain transactions in a timely way.

* * * * *

A predecessor to FINRA conducted its own review in 2005 and found no violations.

* * * * *

FINRA’s full-scale examination in 2007 indicated that parts of Mr. Madoff’s firm had no customers. It doesn’t provide an explanation for this finding.”

So FINRA, for whom an “overarching objective” is ‘investor protection,” found nothing significant to be wrong, and said some part of his business had no customers when he had thousands? What part of his business supposedly had no customers? This is some kind of incredible hogwash. It is obvious that FINRA was as willfully, grossly negligent and incompetent as the SEC.

It is claimed on behalf of FINRA that it could not detect the fraud, the Ponzi scheme, because it has authority only over the broker-dealer side of Madoff’s business, not the investment management scale. This excuse is hogwash, as a number of Congressmen pointed out on January 5th. Madoff was one single overall company, even if it was organized in three parts, proprietary trading, broker-dealer and investment management. If FINRA had so much as competently checked whether the company had the securities and money it claimed, it would have uncovered the fraud.

That is the major point. Moreover, if FINRA could deal only with the broker-dealer part, how could it have known some other part had no clients? Or was it saying the broker-dealer part had no clients -- that would be an amazing conclusion. If it was saying the proprietary trading part had no clients, well, the firm itself was the client and, anyway, why would FINRA have bothered to mention this if it regarded the proprietary trading part as being without clients, since the same would be true of every proprietary trading desk on Wall Street.

And did FINRA, like the SEC, think it was hunky dory to have a one man accounting shop as the auditor for a major broker-dealer? -- for a broker-dealer claiming to FINRA and the SEC to have 17 billion dollars in assets? Gawd!

The bottom line is that FINRA and the NASD before it -- private regulatory organizations who were supposed to protect investors -- fell down on the job just as badly as the SEC.*


* This posting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, or on the comments of others, you can, if you wish, post your comment on my website, All comments, of course, represent the views of their writers, not the views of Lawrence R. Velvel or of the Massachusetts School of Law. If you wish your comment to remain private, you can email me at

VelvelOnNationalAffairs is now available as a podcast. To subscribe please visit, and click on the link on the top left corner of the page. The podcasts can also be found on iTunes or at

In addition, one hour long television book shows, shown on Comcast, on which Dean Velvel, interviews an author, one hour long television panel shows, also shown on Comcast, on which other MSL personnel interview experts about important subjects, conferences on historical and other important subjects held at MSL, and an MSL journal of important issues called The Long Term View, can all be accessed on the internet, including by video and audio. For TV shows go to:; for conferences go to:; for The Long Term View go to:­_LTV.htm.

Tuesday, January 20, 2009

Investing With Bernie Madoff: How It Happeneed, What Happened, And What Might Be Done. Part II.

January 20, 2009

Re: Investing With Bernie Madoff: How It Happened,
What Happened, And What Might Be Done. Part II.

Over the years since 1995, Madoff, as often said in the media these days, made steady annual returns -- on which one paid ordinary income taxes, not capital gains taxes. The rates of return were unspectacular, especially when compared with the returns made by many hedge funds and, during many years, by mutual funds. But on an annual basis Madoff didn’t lose money, which was a major plus. The idea that he made money every month, however, is misleading. There certainly were some months when he lost money, and there were months when he made very little if anything, say a quarter or a half a percent. There were also months when he made, say, a percent and a half or two percent, or sometimes even a bit more. The monthly variations made the whole deal look Kosher, at least to an amateur, as did the variations in annual returns. On the all important after- tax basis, the annual returns were generally between seven and ten percent. They therefore were probably not much more than, and often were certainly much less than, the annual returns obtained by investors who bought stocks or mutual funds in order to make capital gains. For capital gains are taxed at much lower rates than the more-than-one third rate applicable to ordinary income, plus principal invested in stocks and mutual funds appreciates tax free -- so one gets appreciation upon appreciation, as well as on original, tax free appreciation of principal -- until the investment is cashed in, in layman’s language. (One also can’t help remembering that hedge fund managers who were making hundreds of millions or billions per year -- one recently made $1.7 billion in a single year -- paid a tax rate of only 15% on their earnings.)

Also, every month every investor received a lengthy statement of transactions from Madoff. While I personally lacked the training to fully understand them due to their complexity, accountants did understand them. To the accountants, who of course had the required financial training, they made sense. The idea that someone could be making up complex statements of this nature -- and so many of them yet, if the thousands of clients he is recently said to have had is accurate -- boggles the mind even today and didn’t even enter the mind then. I personally never heard a whisper of the remotest suspicion of such invention, and can only say it must have taken a corps of aiders and abettors. The news reports say that something like 20 people worked in Madoff’s “private” office on a separate floor, the 17th, to which no one else in the firm was allowed access apparently. Many of these people must have been involved in making up the false statements and therefore must be coconspirators even though Madoff supposedly claimed to be doing it himself. (Were his brothers, his two sons, and his niece, all of whom were major figures in his firm, also denied access to the private offices? If they were, didn’t they consider it odd that they, his nuclear family members, with whom he worked closely in the business for years, and to whom he apparently was very close on the personal level, were denied access to the offices? Didn’t it raise their suspicions, even if one assumes, as I frankly don’t, that they were innocent of any knowledge of what he was doing?)

So it went for many years. If one wanted to occasionally withdraw money to meet unusual or other expenses, one always dealt with DiPascali (or his assistant) and the check would arrive promptly. If one wanted to invest more money, one again dealt with DiPascali. This was the way it was until December 11, 2008, when Madoff was arrested. Then a lot of information began coming out that must have been deeply unknown to most investors, including me. The information included the shocking fact that the whistle had been blown on Madoff at least as far back as 1999 or 2000, when an investment professional named Harry Markopolos, who had operated with derivatives, had sometimes used the split-strike conversion strategy, and was mathematically expert, had informed the SEC, both orally and in a memo, of reasons why Madoff’s business could not possibly be on the up and up. Markopolos kept at this until, most recently, 2008, one gathers. As one can see from the long-confidential but now public 2005 version of his memorandum, with the arresting title (no pun intended) “The World’s Biggest Hedge Fund Is A Fraud,” Markopolos gave reason after reason why Madoff’s operation could not possibly be on the up and up. (The 2005 version of the memo will soon be made available at Many of Markopolos’ reasons were completely comprehensible even to a layman, let alone to financial and regulatory experts. But, as so often during Markopolos’ eight or nine years of trying to get the SEC to act, it did not stop Madoff in 1999 or early 2000, from 2001-2004, in 2005, in 2006 or 2007, in early 2008, or at anytime until December 11th.

Equally amazing was that an article blowing the whistle on Madoff had been written in 2001 for a hedge fund-industry publication called MAR/Hedge (RIP) by a reporter named Michael Ocrant. This journal was something read by those connected with the financial industry, doubtlessly including at least some regulators, but obviously is not something read by the general public. (I personally, like 99.999 percent of the American population I would bet, did not even know it existed.) The article gave many of the most pertinent, comprehensible reasons given by Markopolos, but the readers of MAR/Hedge (RIP) apparently did nothing. Certainly the SEC did nothing.

Also in 2001, a shorter article appeared on Madoff by reporter Erin Arvedlund. The article, which focused on secrecy by Madoff, and ignored some of the signs that even a layman would understand, appeared in Barron’s. That article was mixed in nature, with much that was favorable to Madoff, and even advised readers how to invest in Madoff if they wished to. In any event, though Barron’s must be read by a larger audience than MAR/Hedge (RIP), this article received no general play from the media (and I personally never heard of it until after December 11th, just as I and most others had never heard of Markopolos or Ocrant). And again the SEC did nothing to stop Madoff. (The Ocrant and Arvedlund articles will also be made available shortly at

After December 11th, however, the media began covering Madoff’s scheme, including the red flags called to the attention of the SEC by Markopolos, several of which were also mentioned by Ocrant and a few of which were mentioned by Arvedlund. I shall focus now on the red flags that would clearly have been of crucial importance even to a layman, had he known of them.

A foremost red flag was that Madoff apparently was not even making the trades of securities shown on the monthly statements. When already suspicious financial experts checked trades shown on Madoff’s statements against actual trades all over the country on the given day(s) -- which experts knew could be done and knew how to do -- they could find no record of Madoff’s supposed trades. The trades shown on the monthly statements were fictitious, a fact which still seems unbelievable a month after the scandal broke. Experts who checked this got out of Madoff. Wouldn’t you get out if you learned that trades shown on your monthly statement were (amazingly enough) fictitious, had not been made, were purely inventions? The expert SEC apparently checked out none of this, however, so the average investor was again left completely in the dark.

Another red flag discussed by Markopolos was that the options market was not nearly big enough to support the number of puts and calls necessary for the volume of trading in stocks that Madoff claimed to be doing. Madoff had apparently denied this, when asked about it in the past, by claiming he was buying options on the over the counter markets, where they are not totaled. But experts (like Markopolos) said Madoff’s explanation could not be true because the whole options market, on the exchanges, over the counter, or wherever, was not big enough to support Madoff’s trading in securities. By a huge multiple, there simply weren’t enough people who were willing to put enough money at risk in puts and calls to support Madoff’s trades in stocks. This meant that Madoff could not be providing the downside protection, via puts, that was key to the deal, and should have been checked out immediately by the SEC. The SEC apparently did not check it out, however, and the average investor was once again left in the dark.

There was also the growth in the amount of money Madoff was managing. Lots of us were under the impression, fostered in the 1990s, that Madoff was investing for family and friends. We knew nothing of huge feeder funds, of recruitment of investors all over the United States, Europe and South America, or of the fact that he apparently was running 6 to 7 billion dollars by around the year 2000 and tens of billions apparently by 2008. This was all news to me after the scandal struck.

Had people known it, what would they have done? Would they have considered it a mark of how good he was and stayed invested? Would they have gotten worried, and maybe even gotten out, because this was so different from what they previously had always thought the situation was? -- Some believe (like I often do) that when things get too big, disaster often, even usually, occurs. Well, it’s impossible to know now what people would have done had they learned the truth about the amount of money Madoff was running and what he was doing to get it. But one thing I do know: the SEC never saw fit to find out and to tell investors the truth.

There also was Madoff’s secrecy. Hedge funds who invested with him, for example, were not allowed to mention his name in their marketing materials. Yet as Markopolos said, if you ran the world’s most successful investment operation, wouldn’t you want that fact bruited far and wide in order to increase your business? The reason for Madoff’s secrecy says Markopolos, was so that the SEC wouldn’t learn what he was doing. And to further maintain secrecy, when huge investors were thinking of putting in money, but wanted to examine Madoff’s books in order to do due diligence, which they of course could afford, Madoff would not allow the examination, claiming a desire not to have proprietary strategies disclosed to any one else. (Well, it looks now like he had good reason for nondisclosure, but it wasn’t to keep proprietary strategies secret.)

There is also the question of leverage (which was not discussed by Markopolos). I have now read a couple of times that Madoff was using leverage of three to one, which means that for every four dollars invested, three came from loans. The use of leverage is very dangerous because, if the market goes down, with three to one leverage your equity (which is one-fourth the investment) is wiped out if the market drops 25 percent. That Madoff was using leverage was news to me, and I’m not sure the articles which said he was doing so were correct. If they were correct, I suppose that the puts (if one assumes he was buying puts) would guard against a 25 percent loss by confining a loss to a point far less than that. Nonetheless, the use of leverage was very dangerous, and leverage certainly was not the deal people like me signed up for.

This brings up a related point. Madoff said he was hedging by buying puts. Yet, Markopolos says, he did not sell his arrangement as a hedge fund, and one never thought of him as a hedge fund. For hedge funds, it is constantly said in the media, use extensive leverage since this creates the opportunity for huge gains. At leverage of 3 to 1, for example, if the price of the share doubles from, say, 100 to 200, the equity share is now 125, or five times the initial 25 percent invested to buy at 100. (I have recently read that some funds were using leverage of up to 40 to 1, which is frankly not believable because, at 40 to 1, a 2.5 percent loss in the price of a share wipes out one’s equity.) Also, hedge funds invest in fancy, complex, incomprehensible derivatives, which always seemed to some of us (I think Warren Buffet for one) a disaster waiting to happen. Since one didn’t know Madoff was using leverage if he in fact was, nor that he could conceivably be involved with fancy derivatives, one simply didn’t think of him as a (potentially dangerous) hedge fund even though he was hedging against losses by (supposedly) buying puts.

Then there were other things, many again mentioned by Markopolos, which were red flags but again the average investor knew nothing of them. There was the now infamous fact that his auditor was a tiny three person shop - - and apparently only one of the three was an active accountant. A major Wall Street firm that is not audited by one of what was the big 8, and is now the big 4, or some similar large firm? How could this not have been a major warning sign to the SEC? And where did this small shop come from anyway? How did it get it involved with Madoff -- Markopolos claims the accountant was Madoff’s brother-in law, and another person at least has claimed the accounting firm was originally Madoff’s father-in law’s and Bienes and Avellino had once worked for it). And, if it got involved when Madoff started, how did it remain his accountant when he grew into a major firm? A very red flag about which thousands of people were completely unaware. The SEC, however, should have been all over this one like a blanket. I wonder: can the SEC point to any other major Wall Street firm with a rinky dink shop as auditor?

There was also the fact that Madoff’s own firm handled his trades and the back office administration and kept custody of the securities. I gather this is the way most hedge funds work, but it is not the preferred method in the financial industry. The preferred method is to have independent firms do these things, in order to make sure that the claimed securities and money exist. That Madoff’s arrangement lacked this safeguard should have been yet another red flag for the SEC.

Also peculiar in the extreme is the asserted fact that Madoff’s family, as was everyone but those who worked on the 17th floor, apparently was barred from the floor where the chicanery went on. If this was true, didn’t his family think it was peculiar that they, who were close to their father, brother, uncle, were barred? And if they weren’t barred, and ever went down there, didn’t they ever see anything or ask anybody about what was going on?

Curiously, Madoff would sometimes claim that his trades were handled in Europe by counterparties (whatever that means), but would tell other people he was making big money on commissions obtained because his firm was handling the trades. If the counterparties were other than his UK office, didn’t his family members ever notice the discrepancy, and didn’t they ever wonder why they were being denied the vast financial benefits that would have occurred if his New York office was handling the trades? Yet they never inquired about any of this?

Given the close relationships involved, it is extremely difficult to believe that none of his family members ever had the slightest inkling that something untoward was happening. And his family, of course, also had close professional and personal relationships with the SEC. His niece, an official of the business, even married an SEC official who had worked on the agency’s minimalistic investigations of Madoff. The family’s relationships with the SEC are, I gather, to be one subject of an investigation being conducted by the SEC’s inspector general.

There were, of course, people on Wall Street who suspected, as did Markopolos, that the Madoff deal was not on the up and up. Suspicions were so strong that their companies refused to do any business with Madoff. I believe Goldman Sachs and J.P. Morgan were two of them. In his 2005 memo to the SEC, Markopolos gave the SEC the names of four highly placed Wall Street executives it should speak with -- one being at Goldman and a second at Citigroup -- because these executives were convinced, based on their expertise in and experience with derivatives, that Madoff’s returns could not be for real.

There were large institutions, and major-league-rich investors, including Arab investors, which hired due diligence firms to investigate whether the institutions or investors should invest with Madoff, and the due diligence firms, after looking into the situation, cautioned against investing with him because of red flags like some of those mentioned by Markopolos. There were fund managers, whom Markopolos talked with, who had money in Madoff but did not themselves believe that Madoff could make money month in and month out, and thought that he was subsidizing losses in bad months. Translation: they didn’t believe him, but left their funds’ money with him anyway because he was doing well by them overall. So all these experts and big league money managers thought Madoff was fraudulent but never spoke with the SEC, and thousands of people who invested with Madoff knew nothing of their views.*


* This posting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, or on the comments of others, you can, if you wish, post your comment on my website, All comments, of course, represent the views of their writers, not the views of Lawrence R. Velvel or of the Massachusetts School of Law. If you wish your comment to remain private, you can email me at

VelvelOnNationalAffairs is now available as a podcast. To subscribe please visit, and click on the link on the top left corner of the page. The podcasts can also be found on iTunes or at

In addition, one hour long television book shows, shown on Comcast, on which Dean Velvel, interviews an author, one hour long television panel shows, also shown on Comcast, on which other MSL personnel interview experts about important subjects, conferences on historical and other important subjects held at MSL, and an MSL journal of important issues called The Long Term View, can all be accessed on the internet, including by video and audio. For TV shows go to:; for conferences go to:; for The Long Term View go to:­_LTV.htm.

Monday, January 19, 2009

Investing With Bernie Madoff: How It Happeneed, What Happened, And What Might Be Done. Part I.

January 19, 2009

Re: Investing With Bernie Madoff: How It Happened,
What Happened, And What Might Be Done. Part I.

As readers of this blog know because it previously was adverted to briefly, this writer has been caught in the Madoff mess. “Victim” is, I guess, the word that accurately applies to thousands of us, even if the word is distasteful or, to some, whiney. There are those, especially people in their 70s or 80s, who have lost everything, who don’t know how or where they are going to live or where their next dollar will come from.

This writer learned of the matter when a person called and said “Bernie Madoff was arrested this morning for running a Ponzi scheme,” or words to that effect. It seemed to me for quite awhile that this was not something I wanted to write a blog about. But slowly my view changed, for many reasons. There were things that weren’t being said in the public press (although some of them have slowly been coming to be said). There were some often quite incorrect substantive views that were being bandied about in the press as near-gospel. The press -- especially papers of record like the NYT and WSJ -- was extensively - - not exclusively but extensively -- portraying the victims as being only a bunch of billionaires and huge hedge funds. The truth, as recognized by many legislators at a Congressional hearing on January 5th, is that a lot of lesser folks got wiped out -- such as the older people, in their 70s and 80s, who lost their last sou and don’t know how they are going to live. The appearance before Congress on January 5th of Alan Goldstein, a 76 year old man who lost everything, helped put a human face on matters, as did one of the few NYT articles to discuss the plight of the aged, in this instance an elderly retired accountant and his wife (who had been a stroke victim). I think Congress ought to see dozens or scores of victims like Alan Goldstein. And maybe my writing can make some small contribution to a fuller appreciation of what happened.

Very unusually for me, this posting will be made in installments. This is due to an unbelievable press of business, and to the length of what needs to be said.

* * * * *

I first heard of Bernie Madoff at some point in approximately the early 1990s. I think it must have been sometime around 1992 or 1993 because one of the points that made a big impression when I heard of him was that the SEC had investigated and had publicly said it found nothing wrong with what Madoff was doing.

The way that had happened was that two Florida accountants, Bienes and Avellino, had for three decades collected hundreds of millions of dollars from clients and others and invested it with Madoff. The returns on the money were of the medium but steady type for which Madoff has become publicly infamous since December 11th of 2008. The SEC had heard of the arrangement and investigated to see if the deal was a fraud of some type.

At the conclusion of the investigation, the SEC said that Bienes and Avellino, who had been collecting the money on the promise of a return of about 15 percent or so, had thereby been selling unregistered securities. But the SEC found that the invested money was still there -- it had not been dissipated or blown -- and it publicly and explicitly said that it found nothing wrong with Madoff. This was of enormous importance to many who invested after 1992, as I did, and who knew that the SEC had said it found nothing wrong with Madoff. How could there be anything more important than to know the relevant government agency had investigated a deal and found no wrong on the part of the money manager?

The exact words of the SEC official quoted by the Wall Street Journal on December 1, 1992 were, “Right now, there’s nothing to indicate fraud.” In the next 16 years, although it received many complaints about Madoff and apparently investigated him eight times, the SEC never warned us of possible fraud, never retracted its initial statement, never warned us that things conceivably could have changed since it said that “Right now, there’s nothing to indicate fraud,” and consequently never gave people a chance to “defend themselves” by withdrawing investments or not making new ones.

The money invested with Bienes and Avellino was given back to the investors. But, the way I heard it, a number of them were intensely (and understandably) disappointed because they had been making consistent decent returns, and they understandably asked Madoff if he would continue to invest for them. Madoff, as I heard it, agreed to continue investing for family and friends as an accommodation to them, doing so, it was said, because he was a good guy -- which sounds absurd to say after December 11, 2008, but was in full accord with his decades-long reputation at the time and for sixteen years afterward -- until December 11, 2008.

What is more, from the day I first heard of Madoff until December 11th, I never heard even a whisper that Madoff was not investing only for a small number of people -- in accord with a claimed initial decision to keep the number small and merely accommodate family and friends -- but rather was seeking investors widely, was investing for huge numbers of people, was getting billions from hedge funds, banks and other institutions. In hindsight call me stupid, but the press wasn’t following what Madoff was doing, I only knew a few people who invested with Madoff and years later heard of one other, I have never lived in circles where lots of people invested with him, and I thought Madoff’s investing was a small operation in an otherwise large broker-dealer.

The period of the 1990s was one in which massive returns were often being sought and obtained by investors and mutual fund managers. Mutual funds were sometimes reaping annual returns of 25, 30, 40 percent and more on their money. To invest with Madoff was, as odd as it may sound today, a conservative type of investment in which one deliberately forsook efforts to make the huge gains often being obtained by lots of mutual funds, and instead accepted smaller but steady gains. Additionally, one accepted that the gains, whether left invested with Madoff or taken out, would be taxed at a much higher rate than was generally true of much of the gains from mutual funds, stocks and other investments. For the gains with Madoff were ordinary income or short term capital gains rather than long term capital gains, and were therefore taxed at the rate on ordinary income, not the far lower rate applicable to long term capital gains. So investors with Madoff were both taking a lower rate of return and paying much higher income taxes than the capital gains taxes whose attainment was all the vogue then. This is deeply inconsistent with a greedy grab for every nickel one could get, as the media has often portrayed it.

Thus it is that I said then and say now that investments in Madoff were thought a conservative investment, not the greed which has so readily been bruited in the media by reporters who do not know, or at least do not write about, the facts. That they were conservative investments, and did not make as much as hedge funds have held out in their marketing materials, is precisely the point recently made by the first rate financial writer James Stewart. And they were, as said, investments in a system and with a guy in whom the SEC expressly had found no fault -- who was, to boot, a leading and highly respected figure on Wall Street. He had been, among other things the Chairman of NASDAQ for three years and a member of the Board of Governors of the NASD. (For those who know financial history, he might in retrospect be thought the Richard Whitney of today.)

In 1995, this writer, who had been hearing about Madoff for a few years, sought to find out whether Madoff would accept an investment from me. At that time -- and until December 11th struck -- I continued to think that Madoff was running only a relatively small overall total amount of money for family and friends. Because I was, defacto, a virtual family member of one of his investors, Madoff accepted my investment. That, at least, is what I thought then. I never knew, until after the scandal broke, that at some point -- whether it was before or after 1995 I do not know -- Madoff began seeking huge amounts of money, began using feeder funds, including feeder hedge funds, was running billions upon billions of dollars, etc. Nor did I know, until December 11th, that there were three parts to Madoff’s business, i.e., that there was a third, investment adviser segment. I had signed a broker/dealer agreement, and thought he was investing my money in that capacity.

So an awful lot was news to me when the scandal broke. But things that were news to me were things that one would have been likely to learn before making investments if the SEC had done its job in 1992: if it had made Madoff explain and prove how he was making money when it investigated the deal in 1992, or if it had made him register as an investment adviser in 1992, or if it had put a stop to the whole business if it already was a Ponzi scheme at that time.

Before I made the final decision to invest, I did the due diligence of which I felt capable and which occurred to me. In particular, I met at Madoff’s offices on April 3, 1995 with the fellow I have always been told and always believed was his number two man, Frank DiPascali, to have him explain precisely what was the investing strategy that was being followed. DiPascali explained that Madoff was engaging in what I now know to be called the “split-strike conversion” strategy. Under this strategy, Madoff bought for one’s account a “basket” of stocks that were in the S&P 100. To guard against losses, he simultaneously bought options, called “puts,” that allowed him to sell the stocks -- to “put” them to someone, if they went down instead of up. To pay the cost of the puts that he purchased, Madoff sold other options, named “calls,” that allowed the buyer of the option to “call” the shares from Madoff after small gains.

By guarding against losses via “puts” while offsetting the price of the “puts” by selling “calls” that limited the gains from each set of transactions, and by highly active trading that repeated the process time and again during the course of a year, Madoff could make small profits on each of numerous trades when the shares rose in value rather than dropped (Madoff was swinging for singles, not homers, said DiPascali), while he guarded against big losses from downturns.

Over the course of a year, the small profits (the singles) on numerous trades of stocks that rose in value, would mount up. This was not a strategy for big hits, but for a small profit here, a small profit there; if shares rose, say, ten percent, the strategy might garner one or one and a half percent (because the calls would require the stocks to be sold). Over the course of a year, the small profits would add up (and would exceed any small losses when stocks went down and would be “put” to buyers).

That the foregoing description of the investment strategy was what was told me is evidenced by contemporaneous notes -- which I still have -- of the meeting with DiPascali on April 3, 1995 -- the meeting with the number two man to a highly respected Wall Street figure. The notes of the meeting say:

The program will work as follows: I will be long 30 to 40 S&P 100 securities. The portfolio is configured so there is a perfect correlation with the S&P 100 index. It is hedged using index options. So if market goes up and you are in a short position on options, it causes the long assets you own to go up.

So you are long a basket of securities -- our core assets -- you have hedges. In a volatile market, you’ll do very well. In an even market or a down market, you’ll do okay.

Your long position is protected against going down by being long on puts on the index. Flip side is you have short calls so there will not be unending appreciation.

They are looking to hit lots of singles. It’s a leveraging type of game. If net goes up 10% you make 1 or 1.5%, while you are protected against losses on downside.

Results vary from month to month -- some months you make zero, some 2%. The goal is to do twice the long term Treasury bill rate. So the goal now is about 15%. Last year just made it. Other years exceeded it. Doesn’t feel will exceed it now because more people (competitors) are doing it and this limits what you can squeeze out.

So the split-strike conversion strategy was what was described to me as Madoff investment strategy, was a system that made a lot of sense to me, was what I invested in, and was all I intended to invest in.*

*This posting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, or on the comments of others, you can, if you wish, post your comment on my website, All comments, of course, represent the views of their writers, not the views of Lawrence R. Velvel or of the Massachusetts School of Law. If you wish your comment to remain private, you can email me at

VelvelOnNationalAffairs is now available as a podcast. To subscribe please visit, and click on the link on the top left corner of the page. The podcasts can also be found on iTunes or at

In addition, one hour long television book shows, shown on Comcast, on which Dean Velvel, interviews an author, one hour long television panel shows, also shown on Comcast, on which other MSL personnel interview experts about important subjects, conferences on historical and other important subjects held at MSL, presentations by authors who discuss their books at MSL, and an MSL journal of important issues called The Long Term View, can all be accessed on the internet, including by video and audio. For TV shows go to:; for conferences go to:; for The Long Term View go to:­_LTV.htm.