Tuesday 16 December 2008

"Jews hit hard by Madoff scheme"

Odd headline, isn't it? Yet that's how Slate is covering the $50 billion fraud perpetrated by New York financier Bernard Madoff. Sadly, though, it's appropriate. It seems Madoff deliberately targeted his co-religionists for his massive confidence trick. Worse, a large number of Jewish charities were heavily invested in the scheme too, and have been effectively wiped out. This would weigh heavily on his conscience, if he actually had one, which he probably doesn't, considering that one of his last acts before he was arrested was to reveal the whole scam to his two sons -- and then tell them to keep quiet while he divvied up the rest of the cash. Fortunately they were too honourable to comply, and blew the whistle on him.

Where has all the money gone? One analyst has said that a lot it has gone to "money heaven", but that's unlikely unless you think that heaven is someone else's bank account. A Ponzi scheme is by its nature a zero-sum game. (Will we stop calling such things Ponzi schemes now? Ponzi was a two-bit crook by comparison with Madoff, and the apparent losses we are looking at here dwarf anything ever seen in the past. "Madoff scheme", anyone?) We know who a lot of the losers are, and we'll get back to them in a second, but a lot of the people who "invested" with Madoff early made some nice returns, albeit at the expense of the latecomers, and presumably got out whole. That group must include more than just the Madoff family, especially as his sons had no idea what was going on. There are suggestions that some of those who did well will be called on to return the money, on the basis that it represents the proceeds of crime. Given that they didn't know that at the time, that might seem unlikely, but there's a precedent, albeit on a much smaller scale.

Then there are the losers. The investment "superwoman", Nicola Horlick, had about 9% of the assets in one of her funds invested with Madoff. She is bleating that it's all the fault of the SEC, which should have spotted what was going on. I don't think that washes, for the humourless Nicola or for any other fund manager who got caught in the same way. It looks as if the entity that actually held the money within the Madoff empire was not in fact regulated. Investors pay Nicola and her ilk big commissions to figure such things out -- it's called due diligence.

Then there are the commercial banks, with Santander, HSBC and RBS already owning up to big exposures. When I first heard this, I thought it was outrageous for banks to be raking in deposits with government guarantees, then investing them in schemes like this. But that doesn't seem to be the story: most of the exposure apparently arises through loans made to individuals to help them to buy into Madoff's funds. It's hard to criticise banks for lending to wealthy clients against apparently sound collateral, though like Nicola et al, they all seem to have been oblivious to the fact that the key Madoff entity was unregulated. The borrowers are still on the hook for the loans, so the eventual scale of the banks' losses may be smaller than they have initially estimated, though with so many people claiming to have been wiped out, that may be a faint hope.

The Madoff fiasco has set me to thinking about how financial regulation might be recast when (if?) things settle down. A former President of my old firm in Canada used to say that banks accepting personal deposits supported by government insurance or guarantee should be limited to investing in high-quality assets -- Government bonds, mortgages, companies' working capital, and so on. Financing for riskier purposes -- capital projects and such -- would have to be raised directly from institutional investors and more risk-tolerant private investors, without relying on any Governmental guarantee. The argument was that this would force both borrowers and investors to price risk more accurately -- and it would, of course, reduce the burden on Government deposit guarantee schemes.

I can see all sorts of problems with this. For one thing, it looks awfully cumbersome for corporate borrowers, compared to the "one stop shopping" of the current system. For another, it's hard to know where you draw the line for eligible assets for the banks. As I suggested above, a loan collateralised by assets in an investment fund such as Madoff's might well be acceptable. There's no way that all risk can be eliminated, no matter how conservative you think you are. Still, with governments everywhere guaranteeing almost all deposits, and with banks having rather conspicuously failed to manage the risks they take with those deposits, serious change is inevitable. More regulation, less risk, better disclosure, smaller bonuses: isn't banking going to be fun?

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