Tuesday, December 16, 2008

Madoff Scam

Madoff's fraud is kind of funny because his purported option strategy didn't make any sense. He was buying stocks, trading options on those stocks, and exiting all positions at the end of every month. The latter point is important because clearly he did not have the positions on, and because he didn't show up as an owner of many stocks through standard reports that show end-of-quarter stockholdings, he needed a story, and for some reason people believed he had good reason to be flat at the end of the month. But all this volume, on options, makes it very hard to make money because you often pay 10 cents each way to the market makers in liquid options. But he made basically 1% a month for years with only a few down months with $17B.

One statement indicated that for an account with $500k, he made a sufficient number of trades that if he did this for all his accounts, he would need to have more options than currently are the open interest at the CBOE by a factor of 10! Something is clearly wrong with that business model, because you just apply the logic applied to your account to what you think Madoff is managing, and the implications become implausible quite clearly.

Now, one can understand a socialite, Stephen Spielberg, or a charity, not getting this. But Tremont’s Rye Investment Management unit had $3.1 billion, virtually all the money the group managed, allocated to Madoff. Walter Noel’s Fairfield Greenwich Group had $7.5 billion out of its $14.1 billion in total assets invested with the manager. All together funds of funds had at least $20.3 billion invested with Madoff, who charged no fees to investors, getting paid instead through commissions from his brokerage business for trading the stocks in the accounts! Thus, they were allocating money to a guy whose purported business model exceeded any back-of-the-envelope calculation of plausibility, and it also made no sense for Madoff to be charging zero fees and making it up on commissions. If you have a 4 Sharpe investment strategy, you would make your profits off the investment fees, not commissions.

It's sort of like if someone tells you they can make 30% above the market buying stocks with no risk, or 100 basis points on a Treasury Bond arbitrage trade. There just is not that kind of edge in these markets, unless you are taking gobs of risk. As he suggested he had no risk, the only reason he could do this was fraud. His numbers were off by a decimal point.

For professional investors, either they are very stupid (possible), or more likely they assumed Bernie's business model was a ruse, he was cheating through insider trading or front-running and they wanted in no questions asked. The problem with a Ponzi scheme is they are doomed to end in disaster. I don't know why people do them, because I simply couldn't enjoy myself knowing all these people I was scamming, who were my friends, would soon hate my guts.


Anonymous said...

Love the blog and the commentary on this. One thing, right now there are a few 100bps Treasury Bond arbs out there, of course these are not normal times.

Anonymous said...

In my experience, liars lie to themselves too.

J said...

Some time ago I made fun of an English Fund promising 30% minimum return in a Middle East financial journal. I was almost sued for damaging their business. I am a coward and recanted saying that 30%p.a. was a reasonable rate of return. Madoff may have unleashed his lawyers to attack anybody remotely suggesting that his numbers were irregular (or too regular). I dont know, I only assume people is very careful these days.