Why Hedge Funds Got Played for Suckers by Madoff

Bernard Madoff's Madoff Securities lost $50 Billion in an apparent Ponzi scheme.

You can read about the details anywhere--try the Wall Street Journal, for example. But the details don't answer one question.

How? How could some of the world's supposedly smartest investors -- hedge funds -- have been hoodwinked by something that, in the rear view mirror, was a blatant scam?

The answer reveals a common myth about trust in business. The myth is that good businesspeople make rational decisions about trust.

They often don't. And in the rush for "best practices," many "good businesspeople" shortchange commonsense for wishful thinking.

I have written about the Trust Equation: the trustworthiness of an individual can be expressed as a function of credibility, reliability, intimacy, and other-orientation. Someone who rates highly on these dimensions, as seen by others, is trustworthy.

But a con man is as good as the gullibility of those who want to believe him. Let's examine the trust equation point by point.

1. Credibility. The man was the former Chairman of Nasdaq, and remains on their nominating committee. He is known as a leader in the industry. And his own website says he has "a personal interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards that has always been the firm's hallmark."

Never mind there were complaints to the SEC, questioning articles in Barron's, unavailable data, and a one-man accounting firm of record. Don't wanna go there, uh uh.

2. Reliability. The man had a multi-year track record of over-market returns. Regular. Dependable.

Never mind that he lacked the data, or explanations, to back up just why those returns were so steady.

3. Intimacy. Many people knew him personally; he was a regular at toney golf clubs in Palm Beach and Boca Raton.

In language we usually hear about mass murderers, acquaintance Jon Najarian said, "He always seemed to be a straight shooter. I was shocked by this news."

And in classic Big Brother language, his lawyer stated -- after Madoff's apparent confession to operating a Ponzi scheme -- stated "he's a person of integrity." And I'm the Pope.

Never mind that "intimacy" may be the easiest factor of the four in the trust equation to fake. It's probably the favorite factor of con men.

4. Self-orientation. Clearly his customers thought he was generous, a regular attendee of the Red Cross Ball, a desirable acquaintance by virtue of his willingness to share advice.

Never mind his broker-dealer business model was under-powered to take advantage of his supposed insights, casting doubt on his motives. Conflicts of interest were present in the situation of a funds manager using a related broker-dealer.

Trust is a funny thing. Trustworthiness can be analyzed. But it often isn't. Which means trust is as much about the one doing the trusting as the one being trusted.

In the days to come, the absence of regulatory action will be rightly noted. Where was the SEC?

But at the same time, let's not forget the willingness of the sheep to be fleeced.

If it looks too good to be true, it is.

There's no such thing as a free lunch.

An emperor without clothes is just a naked man.

We know that untrustworthy people are often greedy. We can protect against that to some extent.

It's harder to legislate against greed and willful stupidity on the part of those doing the trusting.

When commonsense takes a back seat to greed, it's a con-man's market.

Comments

[Snoop2]

BS...........! No one got suckered by Madoof... They were as dirty as he was...

All they wanted was the large return no matter how they got it - legal or illegal, no questions asked!

This is all about a bunch of wealthy greedy corrupt individuals and funds trying to make more for themselves!

[larry278]

There is an old saying; you can't swindle an honest person.

[research]

Yes they can.

Professional crooks take armature investors 90% of the time.

REGULATION and TRANSPARENCY.

Get real.

[Babelfish]

Free market theory says a dodgy fund fails because investors leave. I suspect many of the investors assumed he had some special way of staying ahead of the pack, but as this could be insider trading, they chose not to ask too many questions, but take their annual 10% plus returns...

But all these financial "experts" paid to manage our money turn out to be asleep at the wheel. As a fund of funds, you choose the fund based on risk versus return and the return is good, but when it is consistent quarter-on-quarter for years and they don't fully explain their strategy, don't get involved. It's one of the first things you learn in credit risk training and it's pathetic that they were so lazy, stupid and greedy to overlook the warning signs.

[peacekitten]

jehovah, jehovah, jehovah.

[peacekitten]

parasites.

[peacekitten]

trust, schmust.

these hheedge fund managers *wanted* to believe him because to a person, they are the most money grubbing ppppaa a r a s i t e s on the planet.

i feel the sorriest for the average people who trusted them with their retirements, their endowment funds, all the things that they had so much riding on. in their desperation for a secure future, they forgot the cardinal rule of gambling, i.e., investing.

never put more into stocks and unstable investments than you can afford to lose.

if you're looking for stability, try t-bills. not huge returns, but solid, and reliable.

as for recovering some of the cash, start with take it out of the bank accounts of hheedge fund managers like john paulson, who paid himself $3.7 billion in 2007 as profits taken from the hedge fund he managed. he made almost every dime shorting the mortgage market. in other words, he saw what was coming, kept his mouth SHUT, took his profits from other people's misery, and laughed all the way to the bank. after he paid his 15% capital gains tax on it, since it technically wasn't his "income" for the year.

[peacekitten]

trust, schmust.

these hedge fund managers *wanted* to believe him because to a person, they are the most money grubbing p a r a s i t e s on the planet.

i feel the sorriest for the average people who trusted them with their retirements, their endowment funds, all the things that they had so much riding on. in their desperation for a secure future, they forgot the cardinal rule of gambling, i.e., investing.

never put more into stocks and unstable investments than you can afford to lose.

if you're looking for stability, try t-bills. not huge returns, but solid, and reliable.

as for recovering some of the cash, start with take it out of the bank accounts of hedge fund managers like john paulson, who paid himself $3.7 billion in 2007 as profits taken from the hedge fund he managed. he made almost every dime shorting the mortgage market. in other words, he saw what was coming, kept his mouth SHUT, took his profits from other people's misery, and laughed all the way to the bank. after he paid his 15% capital gains tax on it, since it technically wasn't his "income" for the year.

[DiogenesOfAlaska]

The notion that short-sellers are evil because they profit from the misery of others is flawed.

First, if it were true, then the same would apply for all sales of stock.
Second, if a lot more shortsellers had existed in the mortgage markets a lot earlier, the bubble would have disappeared smoothly, without the bigbang.

Also note that shortsellers can lose big time if their bet is wrong or takes too long to become true.
Yes, it has aspects of gambling. But so does entrepreneurship: the person who runs a business places bets on his firm, asserting that he knows better than others and better than the markets what the correct prices are for what he produces, trades or sells.

Of course capitalism has aspects of gambling. But don't forget that the main problem with gambling is that the gambler loses his money - his own. Gambles with other people's money are a different story. But they are certainly not the fault of the gambler alone.

btw, I am not a gambler.

[solrac2002]

And the Senate doesn't want to pass 14 billion to the auto industry..I'll put some, ahem, money that this dude was the reason that Bush/Paulson wanted the 700 billion..Paulson knew his buddies were about to get screwed. 2 trillion gone with no explanation...Don't send this guy to jail, send him to Detroit and let the auto workers know who he is.

[DiogenesOfAlaska]

I'm not a scientist of relationships of trust, but I'm beginning to be interested in the subject.

Here's what some people in the world of finance can learn from the arts and sciences:
if somebody calls himself innovative, or cutting-edge, or 'transparent', or 'trustworthy', you can place bets that he's an empty suit.

Here's what some people in the arts and sciences can learn from the world of finance:
when you started to believe, back in the 1980s, that it's cool to consider everything as being all about appearances, self-marketing and the all-ever-over-monster-knowledgeable 'market' of ideas, you copied the part of finance that's a dead end. You should have learned and copied something else: that you need to tell the good from the bad ways of counting your chickens.