Thursday, December 18, 2008

Bernard Madoff - Where Integrity crumbled in the Face of Greed

Most readers here should be familiar with the case of the rogue hedge fund manager Bernard Madoff, who appeared in the news after admitting to running a Ponzi scheme of unprecedented scale. He is allegedly the mastermind of the world's largest Ponzi scheme (valued at US$50 billion and counting) and who had been duping investors for quite some years before everything began falling apart like a house of cards. Much has been reported in the news (CNN, CNBC, Time, Reuters and Forbes), each with their own views on the case and also different commentaries about what happened and why it happened. Perhaps I can take the time to dissect some aspects of the case so that we can all learn a lesson about honesty, integrity and greed.

Leaving aside the details of how Madoff managed to fool investors (and amazingly, the SEC) for so long, we delve into the fundamental reason for his deviant behaviour. It all simply boils down to - GREED. Greed of course is simplifying the whole issue, since arrogance, failure to accept losses and probably even self-denial came into the picture somewhere along the way, but the penultimate driving force should have been greed (for money and reputation) because it is like lifeblood for some people - it keeps them going and it fills them with a sense of self-importance. Were investors to know that Madoff had lost money in certain years and opened his fund more judiciously to outsiders, he would then have lost that "awe" which he commanded in his loyal followers. It was precisely because of this hero-worshipping that got so many "sophisticated" investors into deep trouble. Madoff was a man hungry for power and status, and the recognition which came with it. If he had admitted being anything less than infallible, his demi-god status in the hedge fund circles would have been instantly shattered.

The most important thing in investing (and, in fact, all other aspects of life too), I feel, is to have integrity and honesty. Warren Buffett did mention that it takes almost a lifetime to build up a solid reputation but just 5 minutes to ruin it totally, and this is oddly reflected in the way Madoff totally blew everything in just under 3 minutes by confessing to his sons that he was "finished" and had been running a massive Ponzi Scheme all these years. I value integrity more than making money, and would gladly admit to all my investment mistakes, missteps and failures rather than delude myself and others that I am always doing well (and making money). Because once people lose that trust (and consequently, their respect for you), it can almost never be recovered and it's like tying a noose round your neck and releasing the trap door.

Another point I would like to grouse about is the apparent lack of controls and procedures in regulating these hedge funds. The SEC was given ample warnings over the years over Madoff's operations, yet chose not to pursue these leads further. This makes one wonder if the current body in charge of oversight and policing these funds is sufficiently equipped to handle their role competently; or has there been a conflict of interest in allowing Madoff to get too close to them; such that independence has been compromised, allowing familiarity to breed into complacency which then led to the loss of the life savings of so many individuals and retirees. The SEC is probably in need of some soul-searching and after this scandal has been fully investigated, needs to undergo a radical overhaul to ensure this kind of nonsense does not occur again. If necessary, President-Elect Obama could even suggest the setting up of a separate body to regulate the SEC, so that the 2 bodies act as counter-balancing weights such that neither gets too cosy or dominant in terms of influencing decisions which could have a life-changing consequence.

The promise of 1% returns per month consistently through good times and bad stinks of impossibility, as even Warren Buffett (arguably the greatest investor who ever lived) had periods of severe under-performance as the economy and stock market went into periods of extreme volatility. One would have suspected that if something is indeed too good to be true, it sometimes isn't ! Ponzi schemes are perpetuated on the fact that human beings are gullible and will let their guard down when they are greedy for supernormal returns. This also applies to expert investors as much as novices, because we are all subject to human emotions which can cause us to make flawed investment decisions.

14 comments:

Akatsuki said...

Another good article. Since you wrote about "integrity" i would like to know, how do investors know they are investing in companies managed by high intergrified directors n CEOs?

Akatsuki said...

Ok,an argument would be to attend their AGM and ask questions, fine..but how can an investor tell that the management is

1)Candid in the way they speak?

2)Really know what they are doing?

3)Honest with problems?

What words that were said, facial expressions,body language,gestures do you see during etc:Ezra's AGM that made you say they are candid/honest/sincere?

Anonymous said...

It is interesting that warren buffett also started a secretive hedge fund during his early years and some ppl also thought that he was running a ponzi scheme. Unfortunately for them, Warren is a honest guy with an aptitude for investing.While this Madoff guy is simply skim milk trying to masquerade as cream.

Anonymous said...

Good questions, yes how to knw if youre investing in dishonest companies? ???

Anonymous said...

The investors were engaged in a conspiracy with Maddof. They sensed that he was on to something unkosher that would payoff big for a long time as long as the market kept going upward, nobody complained or redeemed and a depression did not occur.

The investors rode this wave in deliberate studious ignorance.Knowing how the great tasting sausage is made requires one to give it up. The mutual tacit agreement (no redeeming in exchange for 12% per annum)fell apart when the redemptions occurred. Game over. The complicit conspirators went down with their host. NO SYMPATHY HERE!

musicwhiz said...

Hello Akatsuki,

There is actually no foolproof 100% method to determine if someone is honest or not. No one has managed to invent a 100% accurate lie detector either hehe. We can only use our best judgement to determine if the Management is acting in the interests of shareholders, or their own interests. Some signs are more obvious, and some less. I had highlighed the MIIF Management's problem in my "Investing Mistakes" section to show one example of how I met Management which I didn't really trust.

In terms of Ezra in particular, the Management has always been very candid and patient and been willing to explain things in detail to me (as a shareholder). Some people argue that some things can still be hidden under such "facades", but then how else do you tell if something funny is going on or not ? Fraud is almost impossible to detect, in cases such as Advance Modules and JEL.

Sometimes it's a matter of gut feel and trusting your instincts, rather than looking out for any visible or tangible signs of problems.

Regards,
Musicwhiz

musicwhiz said...

Hi Anonymous @ Dec 19,

True, your point is quite valid. I read The Snowball and apparently WB set pretty strict rules on investing in his partnership initially which makes it sound oddly like Bernard Madoff's stand-offish attitude to disallow certain people from investing. However it turned out that he was indeed a superb investor with good insights. I think the defining difference is that WB does not boast about super stellar returns, but instead accepts that sometimes things do not go his way either.

Thanks,
Musicwhiz

musicwhiz said...

Hi Anonymous @ Dec 20,

As I said, there is no 100% guarantee that a company is not involved in a sham or scam. We invest with the best of our knowledge and trust our money in the hands of Management, in good faith.

Regards,
Musicwhiz

Anonymous said...

the only reason why he "turned himself in" is to seek police protection from the powerful people he offended.

PanzerGrenadier said...

Hi Musicwhiz

Paul Krugman wrote an interesting article that was featured in Today's weekend edition on 20 Dec 2008

http://www.todayonline.com/articles/293556.asp

Basically, he compares the way Madoff defrauded his investors similar to US investment banks packaging and selling sub-prime loans to investors and reaping obscene bonuses on paper profits that soon evaporated as the collaterised debt obligations and other toxic investments became virtually worthless and untradeable.

The world of investment is full of koyok or snake oil. One of the reasons I became disillusioned with the fund management industry is that for the most part, they produce mediocre or even poor performance and continue to earn their "management" fees when most studies show that majority do not consistently beat their benchmarks in a 20-30 year horizon.

It becomes even more critical for any retail investor to understand the true nature of the investment beast to be able to survive a catastrophic wipe-out caused by such events.

Caveat emptor should not only apply to Madoff type ponzi schemes but even to legitimate investments run by "professionals" who also lost people's moneys in Lehman minibonds and the like.

Be well and prosper!

8percentpa said...

Hi MW

Nice to be reading you no-nonsense posts again! Good job!

I would just like to point out Citiraya with regard to judging mgmt.

The CEO was smooth and convicing on TV, newspaper, to analysts, investors even though he had been doing illegal things for years.

The first warning came when one of the directors resigned, but one couldn't have concluded anything just from this. (And we could only point to that on hindsight as a warning sign!)

Then the stock price started to decline and it was too late when the cat was out of the bag...

musicwhiz said...

Hi Anonymous @Dec 21,

Hey you may actually have raised a very good point ! I think he would need such "protection" after the amazing "stunt" he pulled off !

Cheers,
Musicwhiz

musicwhiz said...

Hello Panzer,

Yes, you are so right. There are so many "snake-oil" salesmen trying to sell products all the time. Years ago, people tried to sell me MLM, more recently, I was approached by Profitable Plots which turned out to be a dubious outfit as well.

Ultimately, we do need to read up more to understand all these before we sink our money in. These people do not have conscience and are ready to just take your money and run. The recent article on a company called UK Prime Land (mentioned in New Paper) also highlights this.. This is why investing in equities makes me more comfortable (even though fraud can occur at these corporations) as compared to other types of "alternative" investments.

Regards,
Musicwhiz

musicwhiz said...

Hello 8percentpa,

Haha oops I didn't know my posts sounded so serious ! I will try to inject a bit of humour now and then in future. :P

Good point about Citiraya. These are smooth criminals with their polished, rehearsed speeches so it can be very hard to tell sincerity from fraud. All I can say is we should buy with margin of safety and be ready to lose ALL in the worst case scenario. But what happens in reality is usually just 1 out of 10 companies end up going belly up and perhaps 1 out of 50 contains super bad eggs. So I am willing to take my chances !

Cheers,
Musicwhiz