Saturday, December 27, 2008

The perception of money lost --- the Madoff swindle

Bernard Madoff says that he has lost at least $50 billion of investor money in a long sustained Ponzi scheme. An intriguing question is whether money that never existed except in fictional statements can actually be lost. That's not to say that his clients weren't royally cheated, but look at this.

Madoff started his investment firm in the 1970's. If the assumption could be made that he had $5 billion under management by 1985, then 10% returns annually for the next 24 years on that initial $5 billion would be $49.5 billion by the beginning of 2009(that's almost now). He generally reported 11 to 12% returns so this calculation is apparently conservative. This analysis is so simple that it is either stupid or brilliant. There were lots of ins and outs of course, but Madoff was so esteemed that until 2008 he always had more money waiting to get in then redemptions needed for life(and death) expenses of his clients. Madoff and those who worked with him managed the in and outs of cash accounts, and it is unclear whether they invested in any successful manner at all.

Did he siphon off large amounts of money? He actually didn't need to do that. He received at least 1% in annual fees on money raised by third parties and more on that directly raised. In addition his clients were charged trading fees and it is reported that the account statements received by clients showed active trading. Digesting that, on $50 billion of clients money Madoff and the 20 or so workers at his firm were likely receiving somewhere between 800 million to 1.2 billion a year in fees. Who knows how much money there was to divert since it's all part of the in and out accounting of the Ponzi scheme, but Madoff was certainly making enough to maintain an extravagent lifestyle money just on the fees generated by the fictional accounting.

One aspect of the reporting on this episode that to some extent supports this total "fabrication of statements" perspective is that a number of market participants have expressed shock that Madoff and his firm managed this much money. How could someone manage as much as $50 billion and never be associated with rumors around the movement in a stock, never be seen by securities analysts, never attend an investor conference, in fact be completely invisible. The firm was not in the Caymans or in Switzerland, it was at 54th and 3rd Avenue in Manhattan. They did not have a name like Alpha X fund or Uppity Lane fund, they were Bernard Madoff LLC. Yet who ever found Madoff as a top ten or top fifty shareholder, or in the case of one Dow stock the top 25o shareholders in required SEC 13-F filings. It is likely that the reason that the Madoff firm was invisible is simply because they did not manage much money in an investment sense. They managed cash inflows and outflows, and lived off of the proceeds. With all that said, it is unclear how much money there is to be found and returned to the clients of the firm.

It may be that the $50 billion lost was never important to the economy in a traditional sense because it was not being invested and risked as capital to build companies, finance r&d, or train labor. It can't be missed because the Madoff firm did not really exist in the role that it presented itself.

This money was, of course, extremely important to the clients of the firm, the wealthy and the foundations that invested, and any alternative to Madoff would have yielded real returns at some level or at a minimum for the last investors in preserved a good portion of their initial investment.

More will be learned, but at this point it is absolutely amazing that this man and some of his colleagues are not in the Tombs or Rikers. I've watched enough Law and Order re-runs(way too many in fact) to have heard the judge say "REMAND" countless times. Perhaps the investigators feel that the best path to the money is one the lets the criminal think about it in his $7 million Park Avenue apartment. Apart from the Madoff family mansions, limousines, jets and toys, can what never existed possibly be found?


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