The Scam That Outscams "The Scam"

The Bernie Madoff Ponzi scheme is generally regarded as the biggest financial scam of all time. I don't agree.

Hedge funds, and particularly "fund of funds," make Bernie's despicable conduct look like small potatoes.

The underlying premise of hedge funds -- outsized returns with no increase in risk--is fatally flawed. Numerous studies have demonstrated the vast majority of these funds do not beat the returns investors could obtain for themselves, by investing in a simple S&P 500 index fund.

It was only a matter of time before these funds started to implode. According to a web site that tracks hedge fund failures, 108 funds at 66 firms have gone of business since 2006. Many more are sure to follow.

While the pitch of hedge funds is a scam standing alone, the "fund of funds" embellished the con. These funds charged 1% or more for selecting and monitoring the performance of "the best" managers.

This scam relied on the gullibility of investors who believe "best managers" is not an oxymoron. The data clearly indicates that it is. If you own an actively managed fund, the odds of it beating its benchmark over 1 year is 1 in 3, over 5 years it's 1 in 5, over ten years it's 3 in 100 and over 25 years it's essentially zero!

How anyone can claim to be able to beat these odds and convince so many sophisticated investors they should pay them to do so, is the poster child for a combination of greed and cognitive dissonance.

Enter the track record of Bernie Madoff. Fifteen years with steady returns of 11%. This was something fund of funds could really sell -- and they did. Some funds reaped hundreds of millions of dollars of fees for simply forwarding billions of dollars of assets to Madoff. These investors felt privileged to gain access to him and were happy to pay the fund fee, secure in the knowledge that Madoff was being closely monitored.

You know what happened next.

Here's the real scam: How motivated were these "fund of funds" to carefully monitor Madoff's performance? Did they really want to kill the golden goose? Or is it likely they either knew his returns were too good to be true or engaged in "willful blindness" to his fraud?

It would not have been difficult to detect his misconduct. He used an obscure accounting firm. He had no independent custodian. These are major red flags.

Or, they could simply have read a 2001 story about Madoff written by Erin E. Arvedlund in Barron's.

The article was skeptical of Madoff's track record and noted "[T]hree option strategists for major investment banks told Barron's they couldn't understand how Madoff churns out such numbers using this strategy."

Of course, real monitoring would have included replicating Madoff's results. No one has been able to do so....and with good reason.

The real beneficiaries of the scam are these funds. Their rewards dwarfed those received by Madoff.

They are the ones who engaged in the scam that outscams "The Scam."

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Comments

[Hugh-Gee]

And Greenspan went "all-in" on hedge funds, claiming that regulation of financial markets was unnecessary because of hedge funds' inherent stability.

He's admitted to having been wrong, but how much damage did he do by putting his heavy reputation behind those scams?

Paul Krugman was one of the very few writers who didn't join in the Greenspan hero-worship. That's one major reason why the dude has substantial credibility.

[davidly]

I love the endless stream of disclaimers at the end; cuz, well, there's a lot a money 'd be "made" out there!

[tamparsenalfan]

Despicable is not taking personal responsibility for your investments. Quality is still strong
fundamentals but long is a foreign concept.

[CTma4pax]

Let’s not forget about the fact that the hedge fund managers have also scammed the public’s treasury out of taxes they should have paid on the enormous incomes they earned for many years. Their fees were in large part, if not totally, set up as a stated percentage of the profits made upon a sale of fund assets, and through the financial world’s ability to accept form, and not look to substance, their self serving product descriptions, accounting statements, and tax returns, quietly set up an “industry custom” and their mis-charac­terization of their fees as “carried interest” went unchallenged. Thus, fund managers were allowed to apply a capital gain tax rate to their managing fees rather than an ordinary income rate. By the time important critics emerged, including key legislators and former Treas. Secretary Robert Rubin, the IRS had already let it slide, had made no timely challenge, even though, under any meaningful analysis, the lack of personal investment in their own fund assets meant their fees were no different than other contingency fee arrangements always taxed as ordinary income. For decades, the wealthy fund managers got even richer as they enjoyed an income tax rate lower than the rest America. Even if their golden days are coming to a close, they are already sitting on large, comfy nest eggs made significantly larger by the estimated $4-6 billion a year in bogus tax savings allowed them. see: http://www.ombwatch.org/article/articleview/3898/1;

[Thermodynamics]

I think this is on-topic because I am pointing out another possible scam.

it pays to question things from an inclusive, commonsense point of view. Like Madoff's whole business, Paulson's actions don't quite make sense.

1. Paulson did not explain what the exotic derivatives did, how they function like insurance, and how they are leveraged, he just rushed us.

2. He never asked for any sort of special legal fiat to isolate the credit markets from the pressure caused by the triggering of the credit-default swaps.

3. It looks like Paulson wanted Lehman to go under. He wrecked their bargaining position during the last few days of negotiations with Barclay's.

[CTma4pax]

"Paulson did not explain what the exotic derivatives did, how they function like insurance.­.."
Ah yes, another example of how the financial movers and shakers successfully coin a new catchy label ("credit default swap") to obfiscate the true substance of the transaction (insurance), in this case so as to avoid not taxes, like my example above, but oversight by insurance regulators. I'm sure we could come up with many more examples of this clever name game.
Why do you think Paulson wanted Lehman to go under?

[Thermodynamics]

Is the rush to the $700B bailout another big scam?

1. Paulson did not explain what the exotic derivatives did, how they function. He just emphasized the threat. If he had provided an explanation in plain English (they are insurance) Congress and the public would have would have demanded some sort of legal fix, not just payments to entities that took excessive risk without adequate reserves.

2. He never asked for any sort of special legal fiat to isolate the credit markets from the pressure caused by the failure of the credit-default swaps. He could have asked for special powers to have mortgages restructured. He could have asked for a moratorium on the "credit events" that trigger the enormous payments required in credit-default swap contracts. This was where the leverage was and constituted the threat to drain the credit markets.

3. It looks like Paulson wanted Lehman to go under. He wrecked their bargaining position during the last few days of negotiations with Barclay's by announcing that there would be no federal assistance, while the talks were ongoing. Lehman's failure precipitated the mess.

[Petrovas]

The Trillion Dollar Stimulus is just another Bailout

Lifeline = Stimulus = Bailout = Bridge Loan

[LeonBNJ]

Remember the 1st rule of investing: If it sounds too good to be true, it probably is.
Then there is a 2nd rule: There are no legal secrets to higher than normal investment gains.
Unless they are using inside information, which is illegal, or ripping off someone, then it is very rare to have higher than normal investment returns in the long term.

[daves1967]

You are absolutely right. Madoff scam is not the largest ever. The largest scam ever is Social Security and that will be blowing up in around 10 years. We are taking money from people who can least afford it to subsidize retirement for people who are ripping off the system. Social Security was created around 77 years ago when most people did not live until 65 and now 77 yrs later with people live to an avg of over 80 it is still 65. Also people paid less in 30-40 yrs ago than now. FICA tax is around 15% vs less than 5% 30 yrs ago. It is an absolute outrage that people having it deducted now will never see a penny in 30-40yrs. Gen X and Gen Y are bankrupt!

[SisterAnn]

Social Security is not a scam. People who draw during retirement will usually have paid into Social Security for 45 years from every paycheck

When you pay into FICA for Social Security and Medicare, you are paying for the right to draw when you retire or become disabled, it also gives your family benefits if you die while your children are under 19 years of age.

It works like insurance. You pay for it while you are working, then you draw when you retire.

When it first started, people who drew Social Security lived to be over 77 years old. Where the confusion comes from is figuring life expectancy from birth. Back then more infants died which skews the table. Figuring from those still living at age 65 is the correct way of figuring it. People are only living 2 and 1/2 years longer, on average, than they did back then.

The tax for Medicare and Social Security is 6.2%, not 15%.

The only way that gen x and y won't get their social security is if they can convince you that you can't have it. You need to stand up for it, if not the average worker will be the only one who doesn't have a retirement. You will be working and paying for the government, judicial system and many federal and state like the military's early and lush retirements until you are 70.

[goldrush]

Social Security is a giant Ponzi scheme. New investors pay the return on the first ones in. This has only been sustainable because we have no choice in our investment. It will collapse anway because congress has given itself the power to steal from it at will.

[Repubnomore]

If I recall correctly, the tax IS up to 15% if you are self-employed. While most workers only pay 6.2%, the employer matches this amount. Since it is a direct cost to the employer, an employee's nominal rate of pay has likely been reduced by this amount.

[BobsNotWorking]

I can see you've never been self employed. Social Security taxes are, in fact, 15%. You must not realize that your employer pays the other half? If you're self employed you have to pay it all and it is 15%.

[Montanagramma]

The rate of 6.5 % is matched by the employer, thus the rate is 13%. Self employed persons pay the entire amount of 13%. In addition, the government has been taking money out of the fund for years. At one point, I believe, money was "loaned" to Mexico from the fund. Later the "loan" was forgiven by Bill Clinton. So, why is it that the SS fund is in trouble?? I wonder. As a person who paid into that fund for 45 years, I believe I have it coming. Remember, people have no choice but to contribute based on wages up to a set limit , which changes periodically. The very rich do not pay over that limit, just like the very poor. While the very rich probably don't care if they ever see the piddly amount of money, they do take it. Check out John Mc's tax return. It is shown.

[montemalone]

http://www.ssa.gov/pressoffice/colafacts.htm

You will see the tax rate is 15.3%.
Self employed pay the full amount, while those who work for someone split the tax with their employer.

[Melbnolan]

I fear as we continue in 2009 to unravel the excess of the last decade 2008 in retrospect may actually look like a "good" year.

[mheister]

The real fundamental problem here is viewing the stock market as a safer version of Las Vegas, instead of being viewed as a means for longer-term investment in corporations, large or small, well-settled or start-up.

Ralph Nader's on to something. A one-quarter of one-percent tax on stock transactions would make quite a few day traders and others treating the market more as a casino than as a means to investment rethink their strategies, to the benefit of all concerned.

[Novista]

Wouldn't it be funny if Bernie is really running a double scam: he confesses to a Ponzi scheme, and it is really something else ...

[lewes17266]

It is a sad scam born of greed in the minds of egomaniacs.
Novista, it is always "something else" and it is always against the law and is always layered and confusing.

It is fraud and it is a very serious crime that continues.

[nezumi]

I could not agree more. I would add that the scam is not limited to Madoff but occurs on a daily level. When moneymanagers have several investors and are not forced to make their transactions transparent, they can favor more important or early investors over numerous late and less important investors. They don't have to shift money from Peter to Paul directly. If they have different assets to allocate over investors, the latter get usually stuck with the most worthless. It is not openly called a Ponzi Scheme but might qualify as a scam on some level. The principal may not get lost entirely as in a Ponzi Scheme but the chance of losses is greatly increased. Maybe more humbleness as an investor (oneself is more likely to be 'fund fodder' rather than beneficiary) could help.

[rich misty]

Ponzinomics

[BillZBubb]

Actually, Reaganomics was the biggest financial scam of all times. We'll being paying for that one for a century.

[hellboundtrain]

Goes to show what quaity you can get for a President from Hollywood, where Nothing Is Real.

Some (many) people live their lives and never engage in reality, but, instead, go from contrived drama to contrived drama never knowing what it means to be honest, forthright, and working to plumb the depths of integrity whenever possible.

[William1950]

well yeah... it's all a scam to make those in the club richer at our expense... I would like to see real jail time for these thieves... or maybe it is truly time to remember our revelutionary history and have another tea party.