I am finding this whole Bernard Madoff scam fascinating. Sad in some ways, instructional in others, and interesting in most.
I find it especially interesting because back in the 1980’s a large group of friends in Colorado got hooked into an “investment opportunity” with M & L Business Machines which turned out to be a major Ponzi scam.
To a large extent I think I can imagine Madoff’s roll in this in the beginning. The desire to be seen as important, successful, beneficent, etc. I even would bet that originally he had no plans for this to be a Ponzi scam (which is significantly different from the M & L scam). Madoff wanted to look good and good returns did that. I am fairly sure he was initially planning that “someday soon” he was going to make “the big one”; the trade or investment that was going to be huge and make up for his losses.
But ego feeds the ego. Once he was on his way to building the image he had always wanted he was never able to stop playing the game and everyone, himself included, became more and more trapped. I think he has known it to be a Ponzi scam for years, even decades, but I wonder if he really thought it was going to collapse. Denial is a powerful force!
“How could this happen?” is a question rocketing around the news rooms and internet. I am finding it fascinating to look at it for myself and in a bigger sense. This is such an “educational opportunity”!
First, just on the practical side of things – there is no way at all that I believe that Madoff was in this entirely alone. He was the main guy and is the “fall guy” but there is no way this huge of a scam was accomplished without others in his company knowing that there was something dreadfully wrong and deciding to play along. I sincerely wonder if we will ever know all the players. But the main interest for me is how it happened in a bigger sense and what I can learn from it.
The first lesson in Investments 101 is to diversify. Investopedia defines diversification as A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.”
Why did organizations and individuals who know this rule lose so much in Madoff’s scheme? Two reasons. The first is that the products that Madoff’s company offered appeared to be quite diversified. An individual and even a manager could have put all of their funds into Madoff’s products thinking they had a “diversified portfolio”.
The second reason is a little more sticky. It involves a responsibility of following things through in detail, due diligence.
How many people reading this (if anyone is!) truly know where your IRAs are invested? Yes, back when I had a retirement portfolio (pre injury) I could have told you that I used UBS Financial and the name of my financial advisor. I possibly could have mentioned the name of a couple of the mutual funds too. But beyond that? I barely took any notice of what stocks were held and traded within the funds. The returns were good and I trusted my investment planner. I passed off the responsibility of detailed due diligence to my investment manager.
In the Madoff case it appears that the responsibility of due diligence was passed down the line over and over:
Investment firms that did business with Madoff have also been sued. New York University said it lost $24 million in investments managed by Madoff, according to a lawsuit filed Dec. 23 in New York state court in Manhattan against fund manager J. Ezra Merkin and his Gabriel Capital LP fund and Ariel Fund Ltd. The school alleged Merkin invested NYU’s money with Madoff without telling investors or performing proper due diligence.
In a separate proposed class-action against Merkin, who is also the chairman of auto lender GMAC LLC, Harry Susman, a lawyer for The Calibre Fund, alleged he misled investors by claiming to have put investor money in a “diverse portfolio of securities.”
Exactly whose responsibility is it in these above cases? Exactly who did not perform proper due diligence? When is it okay to pass off the job of due diligence to someone else? There are going to be many a jury deliberating just such a topic in years to come!
Okay, so the question of Diversification morphs into the Responsibility of Due Diligence.
Another lesson to take away from this is that the definition of Diversification needs to be broadened. Investment Diversification must also include diversification among fund managers and companies not just “within the portfolio”.
I think that is the thing that amazes me the most in seeing some large institutions and charities lose so much money; that they placed all of their funds – tremendous amounts – in the hands of one single fund manager . . . who then invested all of it in Madoff.
I think I will end this post here since it has gotten so long and look at other aspects of “How could this happen?” in some future posts.