Madoff Could Have Fleeced his Victims Legally

What should Bernard Madoff's victims have known and when should they have known it? And what about the hidden 2007 George W. Bush administration decision that helped enable Madoff's crimes?

The first question has a simple answer: most of them should have known from the start not to invest with Madoff, because they were buying into hedge funds. Even if the fund manager is honest, it's not prudent to place your life savings -- or in at least one case, your entire charitable endowment -- in a hedge fund, a risky asset class. Perfectly legitimate hedge funds can clobber investors, as Carlyle Capital did last year. The Madoff victims dominating the news -- upper-middle-class men and women who handed much or all of their life's savings to Madoff -- should never have been at the scene of the crime in the first place. Hedge funds are the Wall Street equivalent of baccarat tables. Never gamble with anything you cannot afford to lose!

Commentators are now lamenting that Madoff's funds were unregulated, but that's because they were hedge funds. (Here is their Securities and Exchange Commission listing under the category for high-risk investments.) The logic of the hedge fund is that it does not require close regulation because only sophisticated, wealthy people and institutions buy into these instruments: such persons and institutions are assumed able to bear losses, and also to understand that portfolio theory says to place only a fraction of what you possess in risky ventures. In order to buy into a hedge fund, the SEC asks you become an "accredited investor," attesting your net worth is at least $1 million, or that your income is at least $200,000 annually and you expect your income to remain at that level. That is, you attest that you are well-enough off to take a big loss and still be okay.

Perhaps as part of pretending to be genuine, Madoff required marks to sign waivers acknowledging they had been warned of a possible loss. All legitimate hedge funds require such documentation. Putting retirement money into an investment that warns of losses is the kind of move those approaching retirement are supposed to avoid. Retirement money belongs in Treasury bills, certificates of deposit, blue-chip bonds or S&P mutual funds. Mutual funds can decline -- reputable S&P funds are down around 35 percent since October 2007 -- but also bounce back, and there is no chance of them going broke. (Broad-market mutual funds would zero out only if Western society collapsed, in which case it would make no difference where you invested.) Hedge funds tank on a distressingly regular basis. Just ask investors in the SageCrest hedge funds, which went bankrupt last summer after about $600 million of investors' $650 million was lost on bad bets.

Most hedge funds impose a minimum $1 million initial purchase, in order to ensure that only those who can afford a loss buy in. Madoff's funds had a $2 million buy-in, a reason all Madoff victims interviewed by today's Wall Street Journal lost more than a million dollars. (Those who pooled funds to meet the Madoff minimum were circumventing an SEC rule intended to protect average people from Wall Street vultures.) The high buy-in was part of Madoff's con-man appeal, along with his preposterous claim to possess "algorithmic technology," whatever that means; Madoff made it seem he was guarding the doorway to a super-secret money machine reserved for a select few. Fairfield Sentry, a Madoff feeder, had a $100,000 minimum buy-in, unusually low, so a middle-class person might have entered the Madoff swindle via Fairfield or a similar feeder. But the same basic reasoning applies. Unless you could afford to lose $100,000, what were you doing putting your retirement nest egg into a hedge fund?

Madoff intermediaries told marks that the financial genius they represented had invented an investing formula that eliminated risk. Adults are supposed to know that salespeople will say anything to get a commission! Anyone who said, "I bought Florida swampland sight unseen because the salesman assured me a major shopping center was about to open nearby" would not receive much commiseration. Many people are financially unsophisticated, or don't read warning forms; many want to believe there are incredible super-secret insider wealth formulas. But in the end, adults must be responsible for their voluntary choices. People whose savings were funneled to Madoff without their knowledge or consent are deserving of unlimited sympathy. Those who actively sought out Madoff became crime victims: but the first step to that status was their own "assumption of risk," as the saying goes. Had most Madoff investors simply followed conventional financial theory about retirement, most would still have their money.

What might the Bush Administration have done to lessen the Madoff damage? In 2006, the Securities and Exchange Commission proposed to raise the requirement for individuals to engage in risky investments to a net worth of at least $2.5 million above home equity. That definition would have barred the upper middle class from hedge-fund investing; in 2006, SEC chair Chris Cox said hedge funds "are not for Mom and Pop," and should be made harder to place money in. But the SEC postponed the rule change after a White House panel said in early 2007 that hedge funds should have only nonbinding self-regulation.

Had the 2006 rule change gone through, many who invested in Madoff Securities in 2007 and 2008 would have been prevented from doing so -- such Madoff victims have every right to be furious at Bush's financial bozos. The rule still needs to be changed, to prevent other average people from investing retirement savings in other risky funds. Let's make sure what happened to the Madoff victims does not happen to anyone else.

Comments

[Justtellthetruth]

The largest companies in the US are being bailed out because they took all of their "eggs" and all of yours mine and every other americans, put them all in one basket and then bet them all that magical risk balancing bonds could turn bad mortgages into gold. Wallstreet sold it, The government bought it, the insurers bought it, the ratings agencies bought it, and it was, like Bernie Madoffs operation, a scam (more of a shell game than a ponzi scheme). since they leveraged themselves at 40 to one, you and I and everybody else are on the hook to bail them out (thus they used our eggs without even asking permission or ever cutting us in on any profits)

Those are the most capable financial people in the nation, yet they put the entire nation in jeopardy due to their greed and foolishness, and not only putting all of their eggs into one basket, but 40 TIMES all of their eggs.

Yet you still say these poor people were especially foolish for investing with a guy who was vetted by the SEC many times, even when the SEC were routinely given hard evidence about the guilt of this charlatan over the course of a decade.

[Henryk A. Kowalczyk - Huffpost Blogger]

The ABC of investing is in allocating only a small portion of one’s money in high-risk investments, that kind that Madoff claimed he managed. Even more, those investments should be diversified.

Just following these simple rules, no one would lose any meaningful money with Madoff.

People lost money not due to greed, or lack of government regulations as many voices claim; I read all comments. They lost their money due to their own stupidity.

The right remedy is more education not more regulations.

[overcat]

"the SEC postponed the rule change after a White House panel said in early 2007 that hedge funds should have only nonbinding self-regul­ation."

Nonbinding self-regulation? That's a euphemism for no regulation whatsoever.

[Eclectic Radical]

"Nonbinding self-regulation? That's a euphemism for no regulation whatsoever­."

Actually, it isn't even a euphemism. It is saying, outright, no regulation whatsoever. A euphemism could actually mean something different, but is understood to mean what it really means. 'Nonbinding self-regulation' can't mean anything BUT 'no regulation', since one cannot regulate one's self and 'nonbinding' guidelines are not 'regulatio­n.'

I'm not trying to be harsh with you, I'm simply trying to illustrate how BROADLY and CLEARLY disdainful of the idea that financial brokers should follow rules of any kind the Bush administration (and many other Republicans, Blue Dogs, and 'New Democrats') really were.

[gfulmore]

Let's make sure what happened to the Madoff victims does not happen to anyone else.

The above comes from the story. Good luck. Just today, on the radio, some guys are hawking a product, an annuity, no doubt, with the inference that the investor either gets 10% per year as the return or the return from the S&P500, whichever is better. How can someone lose? It's a no brainer. But like the Maddoff scheme, it can't work. It makes no sense. You can't be guaranteed that kind of a return. But this stuff will always be out there to those who seek it or are "sold" it. It is a real pity to have folks lose life savings, but the "sharks" will always be there to eat their prey. I'm all for stopping this, but I'm skeptical that it can ALL be stopped.

[Freedomscap]

They aren't victims -- they took risk in the market and lost.

[spinmas]

Madoff wasn't investing!!!

[JohnSawyer]

Yes, we all know that. That's why he's in the news.

[JohnSawyer]

"...a White House panel said in early 2007 that hedge funds should have only nonbinding self-regul­ation."

What the hell is "nonbinding self-regulation"? You get to regulate yourself, but not even your own rules have to apply if you don't want them to?

People have to divorce themselves from the Disneyfication of the human mind that is taking place, and grow up and actually think, and not believe they're cushioned in some big hand, by "God's grace". Never believe anyone who says you can confidently invest with them, even if they have apparent proof--do your own research. Until you have REAL proof that an investment is sound, keep your money in something simple that returns little or nothing, and doesn't reinvest it. Follow the entire chain of methods used by any investment vehicle--follow your money--to see where they're putting it. Don't put any money you can't afford to lose, into anything that puts it into risky investments.

Even yesterday, on CNBC, after everything the economy has gone through, a couple of their "reporters"/paid actors were spouting "Money is made by taking risks, big risks--the bigger the risk, the more money you make." I kid you not--they literally said this. Yesterday, March 13 2009. They weren't referring to why people lost money in the collapse--they said this is how things are, and this is still how you should invest your money.

As I say, the Disneyfication of the human mind.

[americaforme]

On TV an investor said, she thought Madoff was a conservative investment at 10%, she said, others were getting much higher returns, up 25% in some cases. My quesation is why was Wall St. so wide open like the old west, and folks so loose with their cash, at such high stakes? Why didn't they figure the belly of the beast could pop? Gangsters get returns from breaking legs, and various other physical tortures. Banks get returns from mental, emotional, fear scares, of poverty. Better to break a leg than end up blowing your brains out. Is Wall St. going to pay, for its part? The Banks are as bad as Madoff, their schemes just as slick, are they going to pay back the people they screwed?

[zell]

Mr. Easterbrook is correct. All retirees know that they are supposed to invest prudently and sparingly in any fund. We were advised to put our money in government bonds and CD's instead of stocks when we retired. So, why did the retirees and charities put all of their money in Madoff's hedge fund? Greed will make people do things that they will regret forever. All prudent people who invest know that you never put more than one-third into one fund at any time. To do otherwise is self-defeating.

[pfc1369]

The entire financial structure is rotten to the core.

Nothing is being done to change this.

[DRaymond]

Wall street loves the myth of the super stock picker. It fuels the justification for the mangement fees of managed funds (not simply hedge funds), of personal stock brokers, of financial analysts and a great deal of the financial press.

So they were willing to buy into the myth that Madoff had found the formula because it supported the myth that they were themselves trying to live off of. Of course it is possible to beat the market consistently with large sums of money over an extended period of time...jus­t look at Madoff!

But the super-stock picker is a myth. It is possible to get lucky for a short while, and ride that early luck into nice looking compounded growth. But the real fact is that ever if you are so smart at to find the stock that you KNOW should be trading at 35 but everbody else thinks should be trading at 30 it means nothing. Why? Because the price is going to be set by everybody else together. You may in fact be right that it should be trading at 35 but it is going to trade at 30 anyhow.

[research]

Hedge funds

shorting then insuring the bets with bogus

investment insurance(AIG Swaps),

Is causing this crash.

Ban derivatives.

Go to Vegas if you want to gamble.

Get Bankers focused back on

Main Street.

Hedge funds are, and always have been, a scam.

[zizyphus]

Hedge funds exist to launder ill-gotten gains. Until their client lists are made public, it will not be possible to "follow the money" and locate the terrorists, weapons dealers, and narcotraffickers.

[fauve]

"Putting retirement money into an investment that warns of losses is the kind of move those approaching retirement are supposed to avoid."

I see the point you're making, but I actually got a notice to this effect when I deposited money into my bank's money fund, as opposed to a savings account. Do you think those in retirement should avoid money funds too?

[mommamia526]

Do not asssume that all those who were *complicit* knew what they were doing. Many people just learn matters this way: *this is how you do it, now do it, and do not ask questions*. If you had an education in a foreign country and learned to solve math problems in various ways, and you did the same math again in the U.S. you were surprised to find that there is just one solution, and one way to do things. You would hear: *that is not the way we do it in OUR country*. If you asked in economics class about hedge funds and derivatives, even if you asked those questions in Finance class, your answer would be raised eyebrows, as in *are you stupid or som'n*? - but no answer. This, of course, indicates that the professor does not know what the answer is. He too, knows the METHOD and fills in the blanks according to the METHOD. Sometimes the METHOD changes, and then you have to fill in the blanks according to that new METHOD. If, heaven forbid, you would be able to solve a calculus problem with regular arithmetic, or even regular algebra, and get the right answer, that could not be possible. Once a problem appears in a calculus book it is out in a higher realm and of a very different quality. Common sens? That is for the peasants! If the METHOD is Reaganomics, we never deviate from it, until arrival of a new METHOD.

[cruzy]

A rather verbose and vague comment, which simply tries to push off personal responsiblity. The point is quite simple: Some of Madoff's victims had their money funneled into his scheme without their knowledge and consent, and they are deserving of every sympathy. However, most of his "victims," sadly, let their personal greed overrule their common sense. And the ones who profited from getting into the scheme early, understood either explicitly or implicity that they were basically stealing other people's money (that's how Ponzi schemes work, those who get in early on profit from skimming up the funds the later joiner put in). In a sense, many of Madoff's "victims" got exactly what they deserved. This is not to say Madoff doesn't deserve to go to jail, he most certainly does. As for how hedge funds "work," you are not correct that asking that question gets "raised eyebrows. Instead, it earns the response, "Ah, here's an intelligent person." Hedge funds are no mystery, some funds engage in riskier strategies than others, but none of them are "safe" investments. If you can afford to lose the money, then it may be well worth the gamble. Just like for many people, it's worth spending $1 every week to purchase a lottery ticket since the potential payoff, though unlikely, is huge. However, if you don't have the money to lose, then you have no business investing in a hedge fund under any circumstances.