The Inoculated Investor http://inoculatedinvestor.blogspot.com/
The Bernie Madoff-Goldman Sachs Parallel
Faith can be blinding. Decades of built up trust can all be lost in a single day. These are truths that investors all over the world were reminded of the day Bernie Madoff’s $65B Ponzi scheme came to light. As a result of the magnitudeof his crimes and the resultant suffering of charities, feeder funds and investors, the investment managementindustry will never be the same. I’m not insinuating that people will no longer entrust their wealth and savings to professionals. But I do believe that the Madoff stain will not disappear anytime soon. Perhaps one day Madoff willeven replace Ponzi as the namesake of this nefarious scheme. Regardless, as a result of the lasting memory of theMadoff affair, even if it is only a faint whisper, those of us who aspire to make a career in the investmentmanagement business will live with more intense scrutiny and be expected to slowly re-build the trust that has proven to be so fleeting.Maybe this is a good thing. In fact, it was a blatant lack of scrutiny and diligence combined with the deification of the man that allowed Madoff to perpetrate his ruse for so long. It appears that Madoff’s status along with his penchant for secrecy and a catastrophic diffusion of responsibility among his investors dissuaded most fromquestioning what stuck out as improbable returns. If you make your operations opaque enough or claim to havesome undeniable secret sauce, only the most sophisticated and vigilant investors will question the consistent results.Madoff apparently compensated for those brave few by threatening to kick them out of his club and thus preventfurther access to an asset that came to be known as the “Jewish Bond.” That was all it took to keep those other thana lone soldier named Markopolos quiet. In the end, all it took was the near collapse of the entire global financialsystem to induce an admission of fraud and defeat. If you were ever dubious regarding the enormous power of hope, this scandal should put any and all doubts to rest.Specifically, what did Madoff’s investors hope? They hoped the returns were real. They hoped that nothing about hisoperations were illegal. They hoped that even if he had some unfair advantage it was a result of nothing more thansomething as trivial as front running. They hoped his elevated status in the financial community would shield himfrom regulatory and legal scrutiny. They hoped that they could get out before it all fell apart. Human nature dictatesthat we can always come up with an excuse for inaction or inertia. Just one more check and then I will get out. Justone more year of market-beating returns and I will take my chips off the table. Just one more day as a part of thisexclusive club and I will leave the game for good. In the end Madoff’s drug proved to be too powerful for even themost “sophisticated” investors to kick the habit.Glancing up at the title of this discussion, you might wonder what in the world this has to do with Goldman Sachs(GS). Well, it struck me recently that many of the elements of GS’s success are similar to those that made Madoff sosuccessful. Don’t worry; this is not going to be another one of these Goldman bashing pieces that have become soubiquitous recently. I want to it be more of a thought exercise for those who believe that what happened to Madoff’sinvestors cannot happen to them. By highlighting some of the comparable mechanisms I hope to remind people of the ever-present and inherent risks associated with any investment. Why is this so pertinent now? Well, with whatappears to be a speculative rally driven by individuals who seem to be blind to downside risk, I think any analysisthat suggests the need for caution can be very valuable.Without further ado, here is a list of themes that seem to be present among investors in both GS and Madoff:1.Belief in supernatural skills that led to a God-like personification2.Comfort with the opacity of the investment strategy3.The irreplaceable benefit of an elevated standing in the financial community4.Widespread suspicion of wrongdoing (or at least marginally acceptable behavior) with little action byinvestors to learn the truth
The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Let’s start with assessing the first item on that list through some personal anecdotes regarding Madoff viaBloomberg:For Swiss banker Werner Wolfer, the memory of his first encounter with one of Bernard Madoff’semissaries nine years ago is as clear as the waters of Lake Geneva.“It all looked so good,” says Wolfer, who has a master’s degree in economics from the University of St.Gallen.“With every year passing, the worries were a little bit less,” Wolfer says.To hear Patrick Littaye talk, the Wall Street money manager could walk on those waters. “It was like areligion,” Wolfer, 57, says of the promise of steady returns, which would be echoed by other acolytes.“These people firmly believed in the story.”Unfortunately, nothing about investing should be a story or should invoke religious comparisons. Successful moneymanagement requires a diligent and disciplined process and any claims to have a magic formula should be lookedupon with extreme skepticism. While I am certainly not a proponent of the Efficient Market Hypothesis (EMH),there is one aspect of it that is 100% accurate: there is no such thing as a lasting free lunch. Riskless arbitrageopportunities, other than in extreme situations like the ones we have seen in the past year, are often closedimmediately by the market. Thus, Madoff’s investors accepted their returns without acknowledging that sometimessubstantial rewards are accompanied by extreme risks.Similarly, the investors who have driven the share price of GS back up over $160 seem to have blind faith in thecompany’s ability to profit in any market circumstances. Unfortunately, they have reason to believe this is a reality:
Goldman Sachs Group Inc. made more than $100 million in trading revenue on a record 46 separate daysduring the second quarter, or 71 percent of the time, breaking the previous high of 34 days in the prior threemonths.Trading losses occurred on two days during April, May and June, down from eight in the first quarter, the New York-based bank said today in a filing with the U.S. Securities and Exchange Commission. Thecompany made at least $50 million on 58 of the 65 trading days in the period, or 89 percent of the time.Tell me that these results do not seem to be as improbable as Madoff’s long term returns in both up and downmarkets. This astonishing data means that from January to June (let’s call it 130 trading days) GS only lost moneyon 10 of those days. That’s almost like a baseball player batting .920 for half a season. A player who achieved thatfeat would immediately be deemed the best hitter to ever play the game. Since trading is a zero sum game, meaningthat there is a loser on the other side of each winning trade, results like this should be impossible. Unless of course,the winner is cheating or has a skill level that is unlike that of mere mortals. Statistics like these illustrate how bothGoldman and Madoff achieved such a mystique on Wall Street. Further, when the number of days that GS not onlymade a trading profit, but also made over $100M is added to the equation, the whole thing starts to look too good to be true. Obviously, the lesson from the Madoff affair is that what appears to be too good to be true, probably is.From the same Bloomberg article linked above:“It’s very counterintuitive to think that they’d be able to generate this much profit and this much revenue inthe middle of an ongoing recession,” said William Cohan,a former banker at JPMorgan Chase & Co. and
Lazard Ltd. and author of “House of Cards” about the collapse of Bear Stearns Cos.
The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Next, let’s examine the parallels when it comes to the opacity of the investment strategy. We know Madoff advertised that he used a split strike conversion strategy to generate his returns. But when pressed on the details, hetended to be very vague or become defensive. As mentioned above, if he felt people were too inquisitive he wouldthreaten to return their investment. Similarly, GS does not give a whole lot of information about how it generatessuch tremendous trading profits. We know for sure that it coincides with increased risk though. At the end of Q22009, GS’s value-at-risk (the amount the company could lose in a single day)was $245M, up from $184M in May2008. Furthermore, GS continues to hold a huge number of what are known as Level 3 assets on its balance sheet.These are by definition the most opaque assets. For those of you who are unfamiliar with this term, according towikinvest, Level 3 assets are:Financial assets and liabilities whose values are based on prices or valuation techniques that require inputsthat are both unobservable and significant to the overall fair value measurement…Level 3 assets tradeinfrequently, as a result there are not many reliable market prices for them. Valuations of these assets aretypically based on management assumptions or expectations.In other words, kind of like how Madoff made up his returns by printing fake trade receipts, GS gets to decide thevalue of $54B of 8.7% of its total assets. Also, just as Madoff’s investors had no way of learning more about hisstrategy, GS is understandably tight lipped about its Level 3 assets and trading strategy. Now this secrecy is notunique to GS. No bank gives away information that could hurt its own positions. But the question investors have toask themselves is whether or not the amazing returns and the carrying value of assets are likely to be legitimate. Next, when it comes to status there is no end to the amount of influence that GS has on policymakers and regulators.The number of GS alumni who have held or currently hold influential government positions is very welldocumented. What that leads to is the perception among investors that GS is protected, not only from legal scrutiny but from adverse market consequences. I worked with some former Goldman guys and there was a palpableunderstanding that GS would inevitably be the first one to get “the call” or a head’s up from the powers that be. If Hank Paulson’s calls to GS CEO Blankfein during the AIG crisisare any indication, this phenomenon is not justassumption, but a reality. Accordingly, this elevated status has the potential to lull investors to sleep. If you believethat the government will always bail out GS or provide sufficient forewarning prior to a crisis, you will investwithout the potential downside in mind. This is what is known as moral hazard and can lead to a mispricing of risk among investors.Similarly, Madoff’s status had a comparable lulling effect on his investors. He was on the Board of Directors of the National Association of Securities Dealers (NASD). He also had very close ties to Securities Industry and FinancialMarkets Association (SIFMA), served as the non-executive Chairman of the NASDAQ, and was considered a pioneer when it came to electronic trading. The positions he held led his investors to assume that there was no wayhe could be doing anything illegal. Even worse, his insider status among the industry’s self regulatory bodylegitimatized his returns in a way few others things could. Plus, there appears to have been an implicit expectationthat even if he was engaging in some dubious practices, his reputation would allow him to escape with only a slapon the wrist or a stern talking to.Finally we come to what I think is the most fascinating similarity between GS and Madoff. This particular biascomes about when investors have an inkling that something that is not quite kosher is going on but for the most partdecide to ignore their misgivings. Apparently in Madoff’s case his investors suspected that he might be front runningtrades, a practice that is illegal, but not seen as unethical as the scheme he was actually running.From TheEconomist:
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The Bernie Madoff-Goldman Sachs Parallel
This is my comparison of the leap of faith that Bernie Madoff's investors took with that which any recent Goldman Sachs investors are taking. Despite rampant suspicion of dubious practices, both were able to garner significant interest from investors. Included here are some of the parallels.
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