Too good to be true, but not too bad to be true
I am pleased – no, make that proud – to say that I had never heard of Bernard Madoff until last weekend. Maybe I had come across his name when he was Chairman of the Nasdaq, or in the context of Nasdaq trading, the arena in which his company was one of the biggest players. But, in common with a surprising number of other people supposedly ‘plugged-in’ to the investment scene, I had never heard of him in the context of asset management.
That lacuna has now been compensated for, by reading hundreds of pages about ‘the Madoff scandal’ or ‘affair’. Yet I still have no idea how he managed to do what he himself claims he did, let alone answers to the endless list of questions about this mess.
But despite the absence of details, there is no doubt at all that he stole or otherwise expunged many billions of dollars, belonging to many rich people and, worse still, to many institutions serving all people, or specifically poor or needy people. The more you read about it, the worse it gets, but unfortunately there is no such thing as ‘too bad to be true’.
In lieu of the facts about what happened, we have a steadily-growing list of consequences, some clearer than others. It seems fair to say that the Madoff affair will come to be seen as a milestone in the development of three very different groups of people: a) the Jewish world in general and the American-Jewish community in particular; b) the money management profession, extending from private and other banks, through to hedge funds and other ‘vehicles’; c) people with money, whether a little (‘savers’), a lot (‘investors’), or a great deal (‘wealthy’).
Since the scandal and its fallout is going to be with us for a long time, there will be ample opportunity to relate to each of these areas, looking back to where they came from and forward to where they might be going. This blog is therefore likely to be the first of many on Madoff-related topics.
I launched an opening salvo on the subject in my ‘Global Agenda’ column in the Jerusalem Post last Friday (19/12), posted below, in which I chose to focus on the moral aspect of the disaster, with particular reference to American Jews. This triggered a fair amount of response, most of which — but by no means all was positive.
Let’s now move to the professional aspect of the discussion. Although this is limited by the fact that we still know so little regarding the ‘how’, ‘when’ and even ‘why’ of Madoff’s operation, the main issue relevant to the money management profession is absolutely clear-cut and needs no extra details to enable us to draw initial conclusions.
This is that it was perfectly possible to avoid falling victim to Madoff’s scam. Indeed, the managers and firms who maintained their professional standards succeeded in doing so, whilst those who ignored or rode rough-shod over established rules of investment practice – indeed, of common sense – ended up paying a heavy price.
There is already ample documentary evidence from various investment firms, fund managers and (more anecdotally) even individual investors, explaining why and when they chose not to even try and invest with Madoff. Their ‘secret’ was to follow the accepted procedures for checking out funds and fund managers – the process known as ‘due diligence’, which includes such basics as requiring audited annual reports and reading them thoroughly; confirming that the assets under management are traded via third parties and held with an independent custodian (rather than via an in-house firm, as was the case with Madoff’s investment accounts); and generally ‘kicking the tires’, meaning checking that things that are supposed to be there actually exist and function properly.
More thorough due diligence – employed by some firms, but not many — involved trying to find former employees who could shed some light on how the operation was run. The fact is that in the field of ‘alternative investments’, very smart managers were scratching their heads for years trying to figure out not only how Madoff achieved the results he claimed, but also who his team were and how and where they worked. There is virtually no big fund manager about whom the professional community cannot get some information, through the grapevine of traders and brokers who know people who work or (better) used to work there. But in Madoff’s case, no-one knew anyone and hence no-one could verify anything.
The response to this situation – the blackest of all ‘black-box’ investment structures – could only be binary. Either you just took it all on faith – the guy is a genius, he can do what no-one else does and the results speak for themselves – or you said ‘I can’t understand it, it doesn’t make sense, and I can’t take it on faith – so I’m staying out’.
Just how much was involved in taking it all on faith became clear if you did even more intensive due diligence. The investment strategy that Madoff said he used, called ‘split-strike conversion’, required trading options on the S&P 100 index. Managers who tried to replicate his results using this strategy couldn’t do so, even on paper. But never mind the theory; in practice, the amounts of money Madoff claimed to be managing made it impossible to use S&P options, because that instrument wasn’t liquid enough to enable him to trade on the scale he needed to.
In other words, the deeper you dug, the more suspicious you had to become. Like all faith-based inter-personal relationships, those who believed didn’t dig, and those who dug didn’t believe. It really was that simple.
That means that all the big name firms now adorning the hit-list of Madoff’s victims are guilty of either crass stupidity or massive incompetence, or both. There is also the possibility of actual complicity, but this seems extremely unlikely with respect to large financial firms. In general, given a choice between assuming that banks etc. were professionally incompetent or criminally complicit, one should almost always choose the former. Whether there was criminal negligence is, obviously, a legal issue – one for which lawyers will certainly be picking up hefty fees for many years as the Madoff-related suits wind their way through the courts in numerous jurisdictions.
But in addition to failing to act professionally, the professionals – the investment advisers, private bankers, fund managers and all the rest – are ultimately in the same boat as the individual investors in their failure to use common sense. This is not surprising, because the later stages of any financial mania require the suspension of disbelief, the violation of accepted rules of professional behaviour and, above all, the willing abandonment of common sense.
There is one simple rule, which applies to all people – even highly-paid managers in huge financial institutions – at all times. This says that ‘if something seems to be too good to be true, it probably is’.
There you have it: no need for degrees in finance, or for PhDs in maths and physics creating complex ‘models’ based on computer-generated algorithms. Just plain common sense, based on healthy skepticism and a dash of real-world experience.
The most important research that needs to be done in the aftermath of the Madoff affair is by social and behavioural scientists, to try and figure out what happens to these normal human characteristics of common-sense and skepticism in a prolonged financial boom: do they simply get pushed aside by greed? Or do the people who end up as victims have a kind of congenital deficiency in these characteristics, making them predisposed to end up as suckers in some villain’s con game or Ponzi scheme
Whatever the case, the lesson that hopefully will be absorbed and taught by the investment profession is that the well-documented tendency of investors to place avoiding potential losses ahead of earning potential profits, is justified. Something can indeed be too good to be true, but can rarely be too bad to be true.