Detecting Bernie Madoffs

Last week the New York Times ran an installment of its Wealth Matters column entitled How Do I Know You’re Not Bernie Madoff? Literally, it’s an easy question to answer. (Because I’m not in prison.) But figuratively it’s anThree_Card_Monte crop ZioDave important question for which everybody with money to invest should have an answer.

The column starts out with a brief interview with a private wealth manager with the impossibly appropriate name of Tony Guernsey. (A posh off-shore banking center?) And there’s a picture of the fellow. He looks exactly as Ralph Lauren would have him look: tortoise shell glasses, chalk stripe suit, and chin thoughtfully rested in right hand. In the foreground there is (I swear I’m not making this up) a small red flag.

Tony Guernsey has been in the wealth management business for four decades. But clients have started asking him a question that at first caught him off guard: How do I know I own what you tell me I own?

That’s an important and basic question. It is a wonder that it took four decades for clients to start asking, but I suppose the glasses and expensive suit go a long way.

Besides being basic, it is a question that has, or ought to have, a fairly specific answer. You know that you really own what your advisor says you do because the custodian of those assets, which is unrelated to your advisor, sends you statements to that effect and those statements are audited by a reputable firm unrelated to both the advisor and custodian.

As a general matter of principle, there should be a clear separation between the guy who makes the investment decisions and the outfit that holds the assets. It is a lot harder to steal your client’s money if you can’t touch it.

The Wealth Matters column takes a while to get around to making this point and then only obliquely. And there is an even more important answer to the question in the title that is ignored completely.

It is often said that Madoff’s claimed returns were too good to be true. Indeed, that was one of the key arguments made by Harry Markopolos when he tried to get the SEC interested in Madoff. They didn’t get it, and even with the benefit of hindsight most observers of the case seem to miss it also.

The point of too good to be true is not merely a cynical pessimism that great returns are unlikely to happen. The point is that if Madoff was really getting the sort of returns he was claiming, a steady 12% a year with only one or two down months per decade, he would have no need for outside investors. He could have just borrowed the money at rates much lower than 12%. Since he didn’t, a person should have been able to conclude that he was either a) an idiot b) uninterested in making money c) remarkably generous to strangers or d) a crook. The correct answer was d.

The Madoff scam is special not because of how it worked or the warning signs that went ignored. It is notable because of its sheer size and the wealth (and presumed sophistication) of its victims. If you are reading about Madoff and thinking that it is an amusing story about very bad things that can happen to people a lot richer than you, you are being quite foolish.  Most investment scams, Ponzi and otherwise, target those of relatively modest means.

So when your investment advisor convinces you to let him make investment decisions for you, make sure he has no direct access to the money. And when somebody offers to let you in on the ground floor of a sure fire winner, ask yourself why your money is needed at all. Because the correct answer is often d.

[Photo: ZioDave]


  • By Kosmo @ The Casual Observer, June 16, 2009 @ 12:36 pm

    e) Unable to borrow due to bad credit :)

    The thing that is remarkable to me is the people willing to put all their eggs in one basket. Why not spread things around a bit, in case one of the people is a crook? Sure, you might suffer with slightly smaller returns, but it’s not as risky.

    Good point in your post – separation of duties is always a good idea.

  • By Rob Bennett, June 16, 2009 @ 2:29 pm

    clients have started asking him a question that at first caught him off guard: How do I know I own what you tell me I own?

    Robert Shiller makes the point in Irrational Exuberance that the entire stock market is a Ponzi scheme at times of high valuations. That nails it, in my view.

    When stocks are valued at three times fair value, is it reasonable to believe that you “own” what your portfolio statement says you own?

    Not in my book.

    Only one-third of the amount reported on the portfolio statement is real wealth. The rest is cotton candy that is going to get blown away in days to come. So why do the newspapers act as if the portfolio statements are real?

    We’re all little Bernie Madoffs.

    We all like to play games with our money and with the money of others, pretending that there is more of it than there really is for a time. It makes us feel good for a time.

    Then reality hits and that makes us feel real bad.

    The Great Taboo Truth is that Bernie Madoff is us.


  • By Frank Curmudgeon, June 16, 2009 @ 3:18 pm

    Kosmo: I can’t get over the sad stories of people, charities, etc., wiped out by Madoff because they had all or nearly all their money with him. That’s just nuts. (And in the case of Fairfield-Greenwhich just criminal.) You don’t have to be the victim of fraud for that to blow up in your face. Plenty of hedge funds have gone poof the honest way. In my experience, incompetents outnumber crooks ten to one.

  • By Dave C., June 16, 2009 @ 3:22 pm

    Thank you for pointing out to me what should have been obvious, about the fact that if he had some amazing investment strategy, why bother managing other people’s money – just borrow for himself and invest his assets.

    I wonder how many people were passively complicit in the whole thing; realizing that it was probably a sham, but foolishly assuming that they would know when to get out before the “house of cards” came down.

  • By SJ, June 16, 2009 @ 3:58 pm

    “Since he didn’t, a person should have been able to conclude that he was either a) an idiot b) uninterested in making money c) remarkably generous to strangers or d) a crook. The correct answer was d.”

    This part is pretty clever.

  • By GPR, June 16, 2009 @ 4:49 pm

    Great post!

    While D was the correct answer, wouldn’t Madoff simply have claimed he was repeatedly lucky/smart?

    You would only borrow the money at a lower rate IF you were certain you would get 12%. Which he only “knew” in hindsight.

    I’m certain he told his investors that they shouldn’t expect such consistently great results — that’s part of the psychology of the scam isn’t it? That you, the investor, are making the very clever decision to stick all your eggs in this basket.

    And couldn’t Warren Buffet have done the same thing? Borrowed at a low rate, invested wisely and reaped all the profits? So if you do your multiple choice test with him, what answer do you get?

    But very interesting, thought provoking post. With little math. Always a help for me.

  • By Rob Bennett, June 16, 2009 @ 4:57 pm

    “Since he didn’t, a person should have been able to conclude that he was either a) an idiot b) uninterested in making money c) remarkably generous to strangers or d) a crook. The correct answer was d.”

    Perfectly reasonable and non-greedy people could have concluded that a choice “e” applied: that he had the skill needed to have a high likelihood of being able to earn above-average market returns but that there is always some risk to aiming to do so and that he did not want to invest all of his own money in this pursuit, that he was covering his bets by investing some of his money in this way and also earning additional money by helping others to earn outsized returns.


  • By Kosmo @ The Casual Observer, June 16, 2009 @ 5:03 pm

    Yikes. I didn’t even catch the “red flag” symbolism earlier. Kosmo needs his caffeine …

  • By Frank Curmudgeon, June 16, 2009 @ 9:09 pm

    Everybody: Madoff’s numbers were not just good. They were silly good. Absurdly good. Printing money good. I think he had only three down months in twenty years. No down quarters. Buffet has actually had down years, for crying out loud.

    Dave C.: I don’t think anybody invested with Madoff knowing it was a Ponzi scheme. That’s just too dangerous. I know this sounds naive, but I really think that only a handful of people were really in on it. (Although hundreds of people really ought to have known better.) The guys at Fairfield-Greenwich who told their investors they were in a well diversifed fund-of-funds but were actually mostly in Madoff should go to jail, even if they didn’t know it was a Ponzi scheme.

    GPR: I’ve heard portfolio managers graciously say their returns were due to luck, but I never heard one that I thought meant it. If you are up two years in a row you are certain that you have it all figured out and you will never lose money again. Of course, if Madoff had really wanted his “clients” to think he was less perfect, all he would have had to do was invent slightly less impressive numbers. Note that he did not do this.

  • By IndependentOperator, June 17, 2009 @ 12:20 am

    Thank you for not saying that the reason you know your money is really there is the SEC. You are exactly right that the real protection of this fact can come only from a solution like you provide and that only you have the responsibility to set up. The SEC failed in this instance, but it is wrong to fault them — it is impossible for any regulator to protect with 100% accuracy. Regulators are always outnumbered by those they are regulating.

  • By Rob Bennett, June 17, 2009 @ 6:05 am

    Madoff’s numbers were not just good. They were silly good. Absurdly good. Printing money good.

    Can the same not be said of the S&P 500 from 1995 through January 2000?

    How many of us can truly say that we did not fall for the same line of bull that the Madoff investors fell for? He printed phony baloney numbers on statements and people believed them. The newspapers printed phony baloney numbers in the Finance section and we believed them. It’s the same basic concept.

    Does greed play a part in this? Yes. But greed is not the entire story. I personally don’t think it is even the biggest part of the story. The big thing is that our understanding of how stock markets work is primitive today. When no one knows much of anything, anyone can believe just about anything. And when anyone can believe just about anything, every now and again there are going to be some unfortunate souls who happen to be caught in a very wrong place at a very wrong time.

    Ellie Wessel lost something like $10 million or $20 million (I don’t recall the number, but I recall it being huge) for his foundation re Jews who suffered under the Nazis. I am supposed to believe that this happened because this guy is filled with greed? If he is filled with greed, why is the money in a foundation? Why doesn’t he keep it for himself?

    He was trying to help people and he got burned because he doesn’t understand the ABCs of how stocks work. He doesn’t understand the ABCs of how stocks work because no one today understands the ABCs of how stocks work. Bogle doesn’t understand the ABCs of how stocks work, for heaven’s sake. (Buffett knows, but he’s smart enough to keep quiet about the parts that upset people.)

    The first step to learning the ABCs is admitting that you don’t know them. We’re not there yet. I think we will be closer to getting there when we can acknowledge that the S&P numbers of the late 1990s were every bit as nutso as the numbers printed on the statements that Madoff sent to his “investors.”


  • By Patrick, June 17, 2009 @ 12:22 pm

    Great article! Nicely put.

  • By GPR, June 17, 2009 @ 3:57 pm

    Madoff’s numbers were not just good. They were silly good. Absurdly good. Printing money good.

    Can the same not be said of the S&P 500 from 1995 through January 2000?

    But not fictional.

  • By My Journey, June 17, 2009 @ 5:12 pm

    Having seen 18 years worth of Madoff Statements (someone very close to me lost A LOT of money) the precision was amazing. Each statement had stocks, options, CUSIP #s for heaven’s sake! Buying/Selling Records.

    After lengthy convos with this person, his only response is that…this was NOT a 4 man operation, it wasn’t a 20 man operation IT HAD TO BE HUGE.

  • By My Journey, June 17, 2009 @ 5:14 pm

    The detail on this statement had more info than my legit, albeit down, tradeking account.

  • By Frank Curmudgeon, June 17, 2009 @ 6:10 pm

    Interesting! I’d love to hear more. Your close friend was in it for 18 years and directly with Madoff not via a feeder? I’m sure he’s not in the mood to share, but there has been very little in the way of first hand accounts of the details in the media.

    I don’t think that details about trades itself means that there were a lot of people involved. When I started my hedge fund there were only three of us and we managed to generate all that stuff while still actually running a fund. I’m sure we could have made up more if making stuff up was our only job. And of course Madoff Securities was a real firm with a big back office, etc. All Bernie needed to do was feed them a list of imaginary trades and they could produce elaborate reports.

    But did the trades really add up to the profits claimed? Markopolous says that he started on this because he was trying to do the same strategy as Madoff and knew what he was claiming couldn’t be done.

  • By My Journey, June 18, 2009 @ 12:24 pm

    Directly in it.

    He told me the story where a couple months back he needed money to pay taxes and within 3 business days he had a check for north of 6 figures…without any poblems; and this was only a few months before the downfall.

    Additionally & interestingly, Big B demanded more info and docs for the FLP that was set up with him than the Broker-Dealer that employs both of us.

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